Open up to make a capital return

In recent years, a flood of books has appeared on the subject of globalisation, written from all sides of the intellectual divide. Those critical of globalisation point to the harmful effects of trade and financial liberalisation on poor countries. The fact that income inequality between rich and poor countries has increased as globalisation has progressed is often cited as evidence for this. Even strong supporters of trade liberalisation have expressed scepticism about the desirability of developing countries allowing a free flow of capital. The East Asian financial crisis in 1997-98 had seemed to strengthen the case for capital controls or, at least, slowing the pace of liberalisation.

In The Next Great Globalisation , however, Frederic Mishkin of Columbia University argues that emerging nations can turn globalisation to their advantage by pursuing a policy of financial liberalisation. Countries such as Singapore, Hong Kong, Taiwan and Chile have shown it can work. China is often cited as a counterexample of a country that has grown fast despite being financially repressed. However, China grew despite and not because of financial repression, Mishkin argues, and will need to reform drastically its financial system if it is to continue growing as fast in future.

Mishkin argues that far from harming poor countries, globalisation can bring enormous benefits, providing them with the funds they need for development and increasing the pressure from within for reform of the financial system. One of the greatest problems these countries suffer is the lack of a sound and efficient financial system capable of allocating capital to its most productive uses. Such a system can only emerge as the necessary "fundamentals" emerge: strong property rights, an effective legal system and a proper system of regulation and supervision of the financial sector. As Mishkin acknowledges, the evidence that increased financial openness leads to faster growth is mixed. It does not always work. This is because the process of liberalisation is often not properly managed.

Premature liberalisation can make the problems of a country far worse and give globalisation a bad name. The result may be a financial crisis in which output falls, poverty grows and social unrest results - witness Mexico in 1994-95, South Korea in 1997-98 and Argentina in 2001-02.

The most important prerequisite for effective financial liberalisation is the establishment of a proper system of regulation and supervision.

However, rules are of little use unless the system is effective. In most poor countries regulators and supervisors have strong incentives to pursue their own interests rather than those of depositors and the country at large. Reforms are needed to ensure supervisors are independent of the banks and politicians and effective in dealing with cases of excessive risk within the financial system.

Opening the system to foreign banks and capital can help. Not only do foreign banks ensure greater financial stability, but they also increase efficiency by encouraging the spread of best management practices. The entry of foreign banks may also encourage adoption of better prudential supervisory practices, as governments are less likely to bail out foreign-owned banks than domestic ones.

Lastly, the quality of the overall management of the economy matters a great deal. As fiscal deficits are a major cause of financial crises, governments must adopt measures to prevent them. A key aspect of this is the exercise of a tough "no bailout" policy by the federal government in relation to state and local governments. Sound management of the economy should involve a monetary policy based on inflation targeting to promote price stability and avoidance of a pegged exchange rate. Openness to trade can also be crucial by making the country less prone to currency crises and less vulnerable if capital flows should suddenly stop.

In the final section of the book, Mishkin sets out a persuasive set of proposals for reforming the international financial architecture, including the transformation of the role of the International Monetary Fund into that of an international lender of last resort, able to act quickly when financial crises occur.

Mishkin's major theme is that to harness the power of globalisation to achieve rapid economic growth, developing countries must establish a sound and efficient financial system. However, advanced countries also have a responsibility to assist this process, not so much through aid but by lowering tariffs and other barriers that impede trade.

This is an excellent, easy-to-understand and well-written exposition of the benefits of financial globalisation, persuasively setting out the case for financial liberalisation in developing countries - against the tidal wave of much current academic thinking on the matter.

Nigel Grimwade is principal lecturer and head of economics at London South Bank University.