The financial system plays a key role in the economy by stimulating economic growth. This is achieved by financial infrastructure, in which entitles with funds allocate them to those who have potentially more productive ways to invest those funds. Financial system allows funds to be allocated, invested, or moved between economic sectors. They enable individuals and companies to pool, price, and exchange the associated risk. By overcoming the information asymmetry problem, the financial system facilitates balance between those with funds to invest and those needing funds. Capital market can play a crucial role to reduce disparity between the “haves” and “have nots” and ultimately for the establishment of the society oriented towards socialism, within the democratic framework.
Financial integration is a phenomenon in which financial markets in neighboring, regional and/or global economies are closely linked together. Various forms of actual financial integration include: Information sharing among financial institutions; sharing of best practices among financial institutions; sharing of cutting edge technologies (through licensing) among financial institutions; firms borrow and raise funds directly in the international capital markets; investors directly invest in the international capital markets; newly engineered financial products are domestically innovated and originated then sold and bought in the international capital markets; rapid adaption/ copycat of newly engineered financial products among financial institutions in different economies; cross-border capital flows; and foreign participation in the domestic financial markets.
Financial integration among economies is believed to have two positive impacts. It can, on the one hand, improve the allocative efficiency of capital, and on the other hand, help diversify risks. However, the recent global financial crisis, which is widely regarded as the worst since the Great Depression, has raised a question mark to the cited benefits and manifested that the cost of financial integration could be substantial. 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 financial markets 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.
How Financial Integration Helps Foster Investment
Properly functioning capital markets help increase investment by affecting both the supply of and demand for capital in several ways. First, they are a cost-efficient way to attract saving from a large group of small savers, thereby reducing the cost of capital for the firm through the economics of scale. Second, capital markets have two risk-sharing and diversification properties that promote the financing of riskier but higher return investment: they reduce the vulnerability of firms to interest rate and demand shocks by facilitating the process of raising equity by firms, and they reduce risks faced by the investor by easing portfolio diversification.
Developing countries that welcomed excessive capital flows were more vulnerable to these financial disturbances than industrial nations. It is widely believed that these developing economies 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.
Finally, capital markets, like banks, perform a term transformation function. Many investments require a long-time span to generate returns, while investors generally wish to commit funds for a shorter period. With liquid and active secondary capital markets, both requirements can be simultaneous, since investors feel assured that they will have access to their funds quickly and without paying an excessive price.
The Benefits of Financial Integration
Financial integration enhances the role of the capital market in several ways. Most directly, integration expands the supply of investment resources by tapping foreign sources, increasing the demand for domestic securities. The increased demand will drive up the price of domestic securities, raising the price-earnings ratio and reducing the cost of capital. Less directly, internationally integrated stock markets allow wider risk diversification and thereby facilitate the implementation of higher return but risker project. Finally, as noted above, increased foreign activity improves the depth and liquidity of domestic capital markets, key ingredients for these markets to perform their term transformation functions.
The fact that a growing share of foreign investment is accounted for by institutional investors could magnify the positive impact on liquidity since institutional investors are very active traders. With improved liquidity in domestic markets, investors will lower their demands for higher yields, reflecting their ability to sell securities at declining costs, and the cost of capital will decline. These favourable effects should lead to change in domestic agents. The declining cost of capital and the enhanced risk diversification should induce the corporate sector to issue initial public offering (IPOs) and additional shares, including offerings and share in emerging sectors, such as private infrastructure projects. In addition, as liquidity in domestic capital markets improves, new domestic investors will be attracted to these markets.
Financial integration of neighbouring, regional or global economies can take place through a formal treaty in which the governing bodies of those economies agree to cooperate to address financial disturbances. But because of the recent financial crises, there’s been a lively debate among academics about the costs and benefits of financial integration. The advantages of financial integration include better governance, efficient capital allocation and higher growth and investment. But, a higher degree of financial integration also has the potential to trigger severe financial contagion in linked economies during crises. 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.
Financial integration can also help predict consumption volatility because consumers are risk-averse who have a desire to use financial markets such as insurance for their income risk, so the impact of temporary idiosyncratic shocks to income growth on consumption growth can be softened. If having access to a broader base of capital is a major engine for economic growth, then financial integration is one of the solutions because it facilitates flows of capital from developed economies with rich capital to developing economies with limited capital. These capital inflows can significantly reduce the cost of capital in capitalpoor economies leading to higher investment.
Financial Integration and Improvement in Corporate Governance
As noted above, one means through which equity markets increase investment efficiency is by serving as a mechanism for corporate control. In essence, shareholders can exercise their right to change the management of the firm if they perceive that it is not acting in their best interest. In addition, investors can react to weak management performance by selling (or by refraining from buying) shares, actions that can lead to a decline in share prices. In turn, the low or declining share price can influence owners and managers to change their behaviour and improve corporate performance.
Indeed, underperforming firms will have share prices that are low relative to their underlying value and hence will be more vulnerable to takeovers. For example, shareholders may not be able to monitor management without incurring high costs because of information asymmetries. The incentives for individual shareholders (unless their holdings are large) to incur these monitoring costs may be preserve because of the free-rider problem. Information vendors and analysts play an important role in reducing these information asymmetries and enhancing the effectiveness of the market as a mean of corporate control.
Conclusions
Liberalizing foreign access to domestic markets can bring substantial benefits to developing countries like Nepal. Liberalization enables countries to tap into the large overseas pool of capital, bringing in foreign portfolio investment that increases price-earnings ratios and depth and liquidity of the domestic capital market. This, in turn, reduces the cost of capital for domestic firms. Moreover, foreign participation may have important spillover effects on emerging markets in the forms of improved accounting and disclosure practice and human capital. To realize these benefits, however, developing countries need to reduce transaction costs and take other actions to increase the attractiveness of their market.
Asset’s pricing in developing countries is more volatile than in developed markets, and financial integration may increase volatility even further. Volatility and lack of information interact with each other and together constitute a major impediment asymmetry that will, in addition, increase the agency cost for foreign investors. Volatility tends to decline, however, as emerging markets become less prone to fundamentals shocks through improved economic policies and diversification. But excess volatility resulting from information asymmetries and deficiencies will have to be tackled through reforms and improvements in the attributes of the capital market themselves.
Consequently, developing countries that welcomed excessive capital flows were more vulnerable to these financial disturbances than industrial nations. It is widely believed that these developing economies 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. As an apex regulator of the capital market of Nepal, SEBON has to take initiation for financial integration in the form of cross border trading and foreign direct investment and so on. The securities related act, 2006 along with various regulation and guidelines have to improvised for the development of capital market and integrated it globally as a major part of financial integration.
(Acting Assistant Director, Securities Board of Nepal)
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