Financial integration is a phenomenon in which financial

market Market is a term used to describe concepts such as: *Market (economics), system in which parties engage in transactions according to supply and demand *Market economy *Marketplace, a physical marketplace or public market Geography *Märket, an ...

s in neighboring, regional and/or

global economies The world economy or global economy is the economy of all humans of the world, referring to the global economic system, which includes all economic activities which are conducted both within and between nations, including production, consumption ...

are closely linked together. Various forms of actual financial integration include:

Information sharing Information exchange or information sharing means that people or other entities pass information from one to another. This could be done electronically or through certain systems. These are terms that can either refer to bidirectional ''informa ...

among financial institutions; sharing of best practices among

financial institutions Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial insti ...

; sharing of cutting edge

technologies Technology is the application of knowledge to reach practical goals in a specifiable and reproducible way. The word ''technology'' may also mean the product of such an endeavor. The use of technology is widely prevalent in medicine, science, ...

(through

licensing A license (or licence) is an official permission or permit to do, use, or own something (as well as the document of that permission or permit). A license is granted by a party (licensor) to another party (licensee) as an element of an agreeme ...

) among

; firms borrow and raise funds directly in the international

capital markets A capital market is a financial market in which long-term debt (over a year) or equity-backed securities are bought and sold, in contrast to a money market where short-term debt is bought and sold. Capital markets channel the wealth of savers to ...

;

investors An investor is a person who allocates financial capital with the expectation of a future return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...

directly invest in the international

; newly engineered

financial products Financial services are the economic services provided by the finance industry, which encompasses a broad range of businesses that manage money, including credit unions, banks, credit-card companies, insurance companies, accountancy companies ...

are domestically innovated and originated then sold and bought in the international capital markets; rapid adaption/copycat of newly engineered

among

in different economies; cross-border

capital flows In economics, capital goods or capital are "those durable produced goods that are in turn used as productive inputs for further production" of goods and services. At the macroeconomic level, "the nation's capital stock includes buildings, eq ...

; and foreign participation in the domestic

financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...

. Because of financial market imperfections, financial integration in neighboring, regional and/or

is therefore imperfect. For example, imperfect financial integration can stem from the inequality of the

marginal rate of substitution In economics, the marginal rate of substitution (MRS) is the rate at which a consumer can give up some amount of one good in exchange for another good while maintaining the same level of utility. At equilibrium consumption levels (assuming no exte ...

s of different agents. In addition to financial market imperfections, legal restrictions can also hinder financial integration. Therefore, financial integration can also be achieved from the elimination of restrictions pertaining to cross-border financial operations to allow (a) financial institutions to operate freely, (b) permit businesses to directly raise funds or borrow and (c) equity and bond investors to invest across the state line with fewer r without imposing anyrestrictions. However, it is important to note that many of the legal restrictions exist because of the market imperfections that hinder financial integration. Legal restrictions are sometimes second-best devices for dealing with the market imperfections that limit financial integration. Consequently, removing the legal restrictions can make the

world economy The world economy or global economy is the economy of all humans of the world, referring to the global economic system, which includes all economic activities which are conducted both within and between nations, including production, consumption, ...

become worse off. In addition, financial integration of neighboring, regional and/or global economies can take place through a formal international treaty which the governing bodies of these economies agree to cooperate to address regional and/or global financial disturbances through regulatory and policy responses. The extent to which financial integration is measured includes gross capital flows, stocks of foreign assets and liabilities, degree of co-movement of stock returns, degree of dispersion of worldwide real interest rates, and financial openness. Also there are views that not gross capital flows (capital inflow plus capital outflow), but bilateral capital flows determine financial integration of a country, which disregards capital surplus and capital deficit amounts. For instance, a county with only capital inflow and no capital outflow will be considered not financially integrated.

History

Financial integration is believed to date back to the 1690s and was briefly interrupted at the start of the

French revolution The French Revolution ( ) was a period of radical political and societal change in France that began with the Estates General of 1789 and ended with the formation of the French Consulate in November 1799. Many of its ideas are considere ...

(Neal, 1990). At the end of the 17th century, the world’s dominant commercial empire was the Dutch Republic with the most important financial center located in Amsterdam where Banking, foreign exchange trading, stock trading and bullion trading were situated. And it was Amsterdam where Dutch investors directed funds abroad at the time. The Amsterdam Exchange had positioned itself as a world marketplace where many different types of securities and commodities were exchanged. It was also in this period that London and Amsterdam were closely integrated financially (Eagly and Smith, 1976; Neal, 1990); Amsterdam assumed the role as the senior partner in acting as the stabilizing force for London during times of English

financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...

. However, it was in the Classical

Gold Standard A gold standard is a monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The gold standard was the basis for the international monetary system from the 1870s to the early 1920s, and from the la ...

Era (the period from the mid-1870s until the start of

World War I World War I (28 July 1914 11 November 1918), often abbreviated as WWI, was one of the deadliest global conflicts in history. Belligerents included much of Europe, the Russian Empire, the United States, and the Ottoman Empire, with fightin ...

) that financial integration began to take shape in Europe. In these periods, for examples, the securities and foreign exchange markets were closely linked; stock and bond markets were internationally linked; international arbitrage activities were no strangers; and commercial and investment banks in major economies established a linkage (Jackson and Lothian, 1993; Lothian, 2000. Eventually the 1980s and 1990s saw a significant increase in financial integration (Lothian, 2000). For example, facing a sharp increase in real exchange rate volatility and the increased risk in these years, institutions surrounding international finance worked together to address these challenges. Regulatory restrictions on international capital mobility such as capital control, interest rate ceilings, etc. were weakened and removed because such regulatory framework was costly in the new market environment. To contain the adverse effects of exchange-rate volatility, new financial instruments and markets were developed.

Benefits

Benefits of financial integration include efficient capital allocation, better

governance Governance is the process of interactions through the laws, social norm, norms, power (social and political), power or language of an organized society over a social system (family, tribe, formal organization, formal or informal organization, a ...

, higher investment and growth, and risk-sharing. Levine (2001) shows that financial integration helps strengthen the domestic financial sector allowing for more efficient capital allocation and greater investment and growth opportunities. As a result of financial integration, efficiency gains can also be generated among domestics firms because they have to compete directly with foreign rivals; this competition can lead to better

corporate governance Corporate governance is defined, described or delineated in diverse ways, depending on the writer's purpose. Writers focused on a disciplinary interest or context (such as accounting, finance, law, or management) often adopt narrow definitions th ...

(Kose et al., 2006). If having access to a broader base of capital is a major engine for

economic growth Economic growth can be defined as the increase or improvement in the inflation-adjusted market value of the goods and services produced by an economy in a financial year. Statisticians conventionally measure such growth as the percent rate of ...

, then financial integration is one of the solutions because it facilitates flows of capital from developed economies with rich capital to

developing economies A developing country is a sovereign state with a lesser developed industrial base and a lower Human Development Index (HDI) relative to other countries. However, this definition is not universally agreed upon. There is also no clear agreeme ...

with limited capital. These capital inflows can significantly reduce the

cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...

in capital-poor economies leading to higher investment (Kose et al., 2006). Likewise, financial integration can help capital-poor countries diversify away from their production bases that mostly depend on agricultural activities or extractions of natural resources; this diversification should reduce macroeconomic volatility (Kose et al., 2006). Financial integration can also help predict consumption volatility because consumers are

risk-averse In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more ce ...

who have a desire to use

as the insurance for their income risk, so the impact of temporary idiosyncratic shocks to income growth on consumption growth can be softened. Stronger comoverment of consumption growth across the globe can also be a results of financial integration (Kose et al., 2006). Furthermore, financial integration can also provide great benefits for international risk-sharing (Lewis, 1999; Obstfeld, 1994; van Wincoop, 1999 ).

Adverse effects

Financial integration can also have

adverse effects An adverse effect is an undesired harmful effect resulting from a medication or other intervention, such as surgery. An adverse effect may be termed a "side effect", when judged to be secondary to a main or therapeutic effect. The term complica ...

. For example, a higher degree of financial integration can generate a severe

financial contagion Financial contagion refers to "the spread of market disturbances mostly on the downside from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows". Financial contag ...

in neighboring, regional and/or global economies. In addition, Boyd and Smith (1992) argue that capital outflows can journey from capital-poor countries with weak institutions and policies to capital-rich countries with higher institutional quality and sound policies. Consequently, financial integration actually hurts capital-scarce countries with poor institutional quality and lousy policies.

Recent development

During the past two decades, there has been a significant increase in financial integration; this increased financial integration generates a great deal of cross-border capital flows among industrial nations and between industrial and developing countries. In addition, this increase in financial integration pulls global

closer together and escalates the presence of foreign financial institutions across the globe. With rapid capital flows around the world, the currency and financial crises in the late 1980s and 1990s were inevitable. Consequently,

developing countries A developing country is a sovereign state with a lesser developed industrial base and a lower Human Development Index (HDI) relative to other countries. However, this definition is not universally agreed upon. There is also no clear agreem ...

that welcomed excessive capital flows were more vulnerable to these financial disturbances than industrial nations. It is widely believed that these

were much more adversely impacted as well. Because of these recent financial crises, there has been a heated debate among both academics and practitioners concerning the costs and benefits of financial integration. This debate is ongoing.(Kose et al., 2006)

References

{{reflist Economic integration Financial markets