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June 27, 2006

How Can Poor Countries Get Rich?

Without financial globalization, says Frederic Mishkin, poor nations can't reach the next stage of development.


Why is financial globalization so important for emerging market economies?

It’s critical for emerging market countries to have an institutional framework that allows their financial systems to work well. This is frequently not understood — in fact, even some high policy officials don’t understand why finance is important to economic well-being and growth. For an economy to grow, you need money channeled to productive investments. If that doesn’t happen, a country will never make it. One of the serious problems in emerging market countries is their financial systems don’t work well: they don’t have good property rights, and they don’t have a legal system that allows enforcement of contracts — things that we take for granted in places like the United States. As a result, businesses and households often can’t get the funds they need.

Suppose you’re an entrepreneur and you have a wonderful idea. In the United States, even if you don’t have money, you’re able to get someone to give you money. And you can become very rich, with tremendous benefit to society. The high-tech sector is a prime example. But if you live in a country with a financial system that doesn’t work well, people will not lend to you because they won’t be able to enforce their contracts. One of the huge problems in poorer countries is that they can’t get capital to work for them.

Financial globalization is an important part of helping financial systems develop. First, there is the direct effect: access to foreign capital, which lowers the cost of capital and makes it easier to do investment. Then there are all of the secondary benefits for a country’s institutional framework. Financial globalization, like globalization in general, increases competition. If you bring in foreign capital, domestic financial institutions have to do a better job in order to survive. And with competition, these institutions will realize that they have to have a better legal system, with property rights and so forth.

What are the risks of this influx of foreign capital?

Frequently, when a country begins to open up to financial globalization, it is done in a way that benefits the same elites that have been repressing the financial system. And this can be dangerous for their countries.

For example, when Mexico privatized its banks and opened its financial system to the outside world, the business elites took over the banks, putting very little money of their own into them. In addition, they made sure the system allowed the banks to take on huge risk. If the banks got in trouble, the taxpayers would bail them out. The result was the banks blew up and the financial system faced a devastating crisis. Similar problems happened in Korea. Banking institutions were essentially lending machines for the businesses that owned them.

This pattern is a very common one. Although financial globalization is critical to growth, it’s frequently mismanaged. There are many examples where it has been successful and many examples of when it has been a disaster.

What about income inequality? Some say that globalization will increase the gap between the rich and the poor.

There’s always been a concern that globalization might increase income inequality. But for poor countries, globalization tends to be one of the most important ways of eradicating poverty. Look at what’s happened in India and China. They entered the global trading system, and as a result a huge number of people have been lifted out of extreme poverty.

However, there have been countries that have not been able to take advantage of globalization, frequently because of bad policies. What we’ve found is that countries that don’t take the proper steps to globalize actually lose out. Not only do they not grow as fast as countries that globalize, they sometimes see declines in income.

In advanced countries like the United States, globalization may have led to increased income inequality in recent years. There’s a lot of debate about this, and there is no clear-cut answer. It’s one reason why some people are opposed to globalization, because they feel that some elements of society may not do as well. But you also have to think about the really poor people. There aren’t just workers in the United States, there are workers throughout the world. And globalization is very beneficial to them. Furthermore, there are better ways of compensating workers who lose from globalization than stopping globalization altogether.

Is this risk for emerging market countries one of the reasons financial globalization is so controversial?

Financial globalization is much more controversial than trade liberalization, and one reason is that many economists don’t understand the importance of finance to economic growth. It’s a very new literature.

Another reason is that financial globalization in emerging market countries has sometimes proved to be disastrous because it’s mismanaged. But the real issue is not whether it’s good or bad but whether it can be done right.

How can these countries get it right?

One of the key issues is that a country must supervise its financial sector to make sure it doesn’t take on excessive risk. This is something that is done very actively in advanced countries, though not always well. We’ve had our crises too. The United States had a savings-and-loan crisis because regulators weren’t doing a good job. But when an advanced country makes a mistake, it usually fixes it.

Another important issue is what’s called currency mismatch. Frequently, businesses in emerging market countries borrow money in foreign-denominated currencies because it’s easier. But their revenue and the value of their assets are denominated in domestic currency. If the value of the domestic currency declines, it blows up the value of their debt and blows up the companies, and that blows up the country. So one issue is how to limit currency mismatch.

Also, trade liberalization actually helps prevent financial crises. If an economy is open to trade, many companies are exporting and a lot of their revenue will be in foreign currency. When they then borrow in foreign currency, it doesn’t create a problem.

How can the advanced countries help?

First, you want to provide incentives for emerging market countries to get financial globalization right. One way is not bailing out countries that are pursuing bad policies. This has been a very big problem with both the World Bank and the IMF, which frequently give money to governments that are doing bad things.

Advanced countries can promote financial globalization by allowing poor countries to send their goods and services to us. This encourages them to export. If they export, they need to get capital. And they will need to improve their institutions to make financial globalization work well for them.

 

Frederic Mishkin is the Alfred Lerner Professor of Banking and Financial Institutions at Columbia Business School. His new book, The Next Globalization, will be published by Princeton University Press in September 2006.

Read the Research

Frederic Mishkin

"The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich"

View abstract/citation 


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