Two parallel developments in the financial sector have defined present-day globalization as much as technological developments and the growth of international trade. The first is the development of the financial markets, institutions, instruments and mechanisms in developed countries. The second is the growth in capital flows across borders in several ways, including foreign direct or short-term portfolio investments or transactions in foreign exchange markets as a result of the deregulation and liberalization of the financial sector in the industrialized and many developing countries.
There has been an exponential growth in the size, operation and sophistication of financial markets in the advanced industrial countries, illustrated, among other things, by the growth and complexity of financial services, especially the expansion of stock markets. This has been accompanied by their "democratization" to cover more and more ordinary, small investors. For example, the number of stock-owning workers and farmers in the United States is estimated to have risen 106 per cent between 1989 and 1995. Though the extent of stock ownership in Europe and elsewhere is not nearly as high as in the United States, it is growing, along with a similar trend towards more middle-income and even low-income investors beginning to share in the growth of the economy by purchasing stock. Privatization of publicly owned corporations in some countries, accompanied by promotion of the idea of employee shareholding, has played a key role. As a result, in France, roughly three fourths of all employees in privatized companies are shareholders in their companies.
It is against the backdrop of the increasing size, depth and complexity of financial markets in developed countries that the quantum increase in capital flows across borders has taken place in recent years. According to recent United Nations Conference on Trade and Development (UNCTAD) estimates, worldwide flows of foreign investment rose by 41 per cent from $468 billion in 1997 to $660 billion in 1998, and to a record $827 billion in 1999, an increase of 25 per cent. Nearly three quarters of that increase, or an estimated $609 billion, took place among industrialized nations, with the largest share in the United Kingdom and the United States.
The composition of capital flows has changed, with private capital and short-term investments dwarfing governmental flows and longer-term investments. Short-term capital flows have grown spectacularly and, partly reflecting the integration of financial markets, transactions in foreign exchange markets are nearly 80 times larger than world trade. The share of official financing in total capital flows fell from over 50 per cent in the 1980s to 20 per cent in the 1990s. While official flows declined from $56.9 billion in 1990 to $47.9 billion in 1998, net long-term inflows to developing countries increased from $101 billion to $338 billion in 1997 before declining somewhat in 1998 with the Asian crisis.
Capital flows from industrialized countries to developing countries accelerated in the 1980s and tripled between 1990 and 1996. FDI has been growing faster than international trade. Portfolio capital mobility accelerated even more rapidly in the 1990s. Cross-border share dealing has grown 10 times as fast as national incomes. FDI flows have been shifting from the primary to the manufacturing to the service sector, and there have been increasing flows to agri-business. However, such capital flows remain highly concentrated, going from a small number of developed countries to a small number of emerging markets. In 1998, the top 10 recipients accounted for 70 per cent of FDI flows to developing countries, while least developed countries accounted for less than 7 per cent. FDI flows to developing countries as a whole rose by 15 per cent to $198 billion in 1999, after stagnating in 1998. Latin America attracted $97 billion, one third of which went to Brazil, while $91 billion went to Asia, $40 billion of which went to China, the largest developing country recipient of FDI. Central and East European countries retained a stable flow of about $20 billion. Africa received between $10 and 11 billion, with Nigeria accounting for $2 billion and South Africa 1.3 billion.
Cross-border mergers and acquisitions, whose announced value exceeded $1,100 billion in 1999, were the primary mode of entry into foreign markets in industrialized countries and are playing a growing role in developing countries. They have helped enterprises achieve better economies of scale, stay abreast of technological developments, maintain competitive advantage and mark their presence in as many nations as possible. Deregulation and privatization in Europe, Japan, the Republic of Korea and some developing countries and economies in transition have opened new opportunities for acquisitions by large multinational corporations. Such acquisitions have benefited consumers in the form of more efficient industries and utilities, access to imported goods and better services in some areas. But they have also, in many cases and certain periods, led to restructuring and closures of production facilities and social costs in terms of losses of jobs and incomes. In some cases, they have also been accompanied by doubts about the sensitivity of foreign ownership to national concerns.
The opportunities and challenges posed by globalization can be illustrated by the experience of East and South-East Asian countries. There, competitive, export-led growth and openness to foreign investment, both direct and portfolio, facilitated by an external policy environment that strongly advocated such policies and a leadership that was prepared to force the pace of development, generated rapid and strong economic growth, greater integration into the global economy and healthy advances in social development. Inflation rates were modest and monetary and fiscal policies considered prudent. Poverty was significantly reduced all over the region, employment levels were enviable, and while inequality and regional economic imbalances may have been aggravated in some areas, problems of social integration in general were diluted by the general progress.
The financial crisis of 1997-1998 characterized by a sudden loss of confidence on the part of investors and swift withdrawal of investments, and its rapid spread to other developing countries and countries with economies in transition, at one stage threatening even industrialized countries, also exposed the risks inherent in such close integration with the global financial markets. The five countries most affected by the crisis (Indonesia, Malaysia, the Philippines, the Republic of Korea and Thailand) experienced a turnaround of $105 billion in a single year from an inflow of $93 billion to an outflow of $12 billion, representing 10 per cent of their combined GDP. Most of the swing occurred in commercial bank lending and short-term portfolio flows. GDP declined sharply and the impressive strides in poverty eradication were abruptly reversed and compounded by problems of heightened inequality, unemployment and social tensions, with particularly adverse impacts on the poor and on women. The crisis showed that even more advanced developing countries that enjoyed strong macroeconomic fundamentals and were regarded as successful examples of liberalization and economic integration were vulnerable to shocks that could set back decades of economic and social progress.
The policies and actions of international financial institutions that advocated such liberalization and stressed structural adjustment and fiscal prudence when the crisis struck were viewed by many as exacerbating the negative social impact of the crisis. It has provoked a rethinking within these organizations in favour of the need to factor the social dimension in their handling of crises as well as in long-term development and a recognition of the risks inherent in capital account convertibility.
The liberalization of financial flows, floating exchange rates, financial innovations and new communications techniques have increased financial transactions enormously, as well as the opportunity for developing countries to attract foreign investment and capital for purposes of business and development, albeit on commercial terms. But they have also compounded a volatility inherent in these markets as a result of radical shifts of perception or in the interpretation of information, and sharp revisions of expectations not always based on sound considerations, that have resulted in panic reactions, contagion and periodic crises. Moreover, short-term capital flows, far from being a mere reflection of economic fundamentals, can actually push key macroeconomic variables, such as exchange and interest rates and the prices of such assets as property and shares, away from their long-term equilibrium and consequently affect output and employment.
Regardless of who or what triggers such inherently destabilizing movements of capital, their occurrence is a matter of concern to investors and receiving partners alike. Economic interdependence cuts both ways. Under favourable conditions, it helps everyone; under unfavourable conditions, it hurts everyone. For investors, financial shocks necessitate costly bail-outs that are controversial in themselves. For the recipient country, they usually mean austerity, unemployment and painful adjustment processes. The absence of principles to guide debtor-creditor relations in periods of distress has tended to magnify the severity of these crises, with costs frequently being borne by the poor and more vulnerable. Typically, the weaker partner, usually a developing country, is forced to bear a heavier burden of the "costs" of volatility. The interests of investors are taken care of before the interests of workers and others more directly affected in terms of employment and livelihood. This is possible because the investors are located mainly in wealthy countries and are able to negotiate more favourable terms and cushion the shock.
A number of measures for reducing such volatility have been proposed. These include taxes on short-term capital inflows, preferably coordinated internationally; improved regulations and supervision of financial institutions; policy stability; diversification of sources of capital; Chilean-type "cooling" mechanisms or reserve requirements; regulation of mutual and hedge funds; special facilities to deal with capital accounts-related currency crises; and greater disclosure and transparency of financial information, among other proposals. They have also prompted calls for a reform of the international financial architecture.