Theme 3

(A) Opportunities and challenges

Globalization and liberalization of financial markets bring a variety of changes, presenting opportunities as well as risks both in economies and financial systems throughout the world. One fact is quite clear: the undeniable benefits of globalization are only available to the countries that best manage their economies.

(1) One obvious benefit of globalization is that active international capital flows improve the efficiency of the allocation of world financial resources. As the world market economy has become more globalized, a rapid growth in world trade has been, leading to a higher standard of living during the 1980s and 1990s. In plain language, competition, productivity gains, lower trade barriers and lower cost of external financing on a worldwide basis are the key factors that have led to growth in world trade and rising standards of living.

(2) Globalization also has increased and enhanced competition worldwide. There are several factors behind this consequence.

(a) Firstly, the integration of world markets and rapid technological change led to efficiency gains and growth driven by the lower transaction and information costs. These in turn increased competition through lower costs and higher market efficiency, higher productivity, lower barriers to entry, and new investment opportunities. Geographic distance is no longer a factor that limits the provision of goods and services.

Hence, competition both in the industrialized and developing countries has reached almost the same level. At this point, it is worth noting that many developing countries, particularly emerging market economies, have actively participated in the world trade and global economy over the last two decades. The presence of emerging market countries, particularly the Asian economies, is growing, and their share in world trade has increased significantly.

(b) Secondly, the importance of non-bank financial institutions in the financial intermediation process has increased. The main examples of these institutions are securities firms, insurance companies and mutual funds.

Therefore, the higher the level of international competition, the higher the economic growth, the higher the income level, the higher the quality of products and thus the higher the living standards the globalization process would bring.

(3) Globalization reorganized some concepts such as stabilization, risk-taking, supervision and regulation of banking systems, market discipline, public guaranty on deposit and moral hazard.

As I mentioned earlier, parallel to the development of new financial instruments and markets and the resultant more complex and dynamic transactions, risk measurement and risk management techniques have changed dramatically. Financial institutions have increasingly been using internal rating and other risk measurement systems and models such as VAR, stress and back testing, and scenario analysis.

As a result of these developments, every trading institution, including central banks, has become more exposed to changes all over the world economies and financial markets.

Indeed, the recent Asian financial crisis revealed that the financial and economic stability of emerging market economies is extremely vital for global financial and economic stability.

(4) Banking business and banking transactions have become very complex. Development of offbalance sheet transactions and derivative markets had an enormous impact on the banks’ balance sheet structure, level and variety of risks to which they are exposed. Based on these developments, the importance of derivative instruments in banks’ risk profile has increased.

(B) Risks arising from globalization

If we evaluate the risks arising from globalization, we realize that there are losers as well as winners in the process of globalization.

It is a well-known fact that the process of globalization does not evolve equally worldwide. Some countries obtain great benefit from the process, mainly driven by their rapid integration into the global economy relative to other countries. In other words, the integrated global economy does not guarantee that the benefits of globalization are shared by the all countries involved in the process.

More importantly, opportunities provided by the globalization process are not always beneficial, as shown by the recent crises. Hence, the process of globalization always carries social, economic, financial, cultural and even political risks in addition to the risk of contagion.

There are several reasons for this situation. Some of them are beyond the control of the countries involved such as external shocks and other unexpected changes in external environment. Indeed, most of these reasons are due to:

- weak macroeconomic and financial policies implied;

- inconsistencies in domestic policies;

- increased vulnerability of national economies to external shocks;

- higher international capital mobility (ie higher sensitivity of international capital flows

among economies);

- higher volatility of exchange rates due to integrated financial markets, which hits real sectors

of economies.

As countries’ economies become more vulnerable to external changes, they are exposed to shocks and crises with severe consequences both in financial and real sectors, as well as facing heavy social costs.

In this context, I would like to emphasize the importance of the risk of contagion in highly integrated global financial environment. As we have all experienced, instability emerging in one country can spread almost instantly to other countries. There is no doubt that every country faces its own challenges that are directly affected by their particular economic and social conditions.

Positions taken in one country are now being hedged in another and this so-called proxy hedging of country risks spreads shocks and crises across national borders. As a result of this, even a country with no direct exposure to the country in crisis could find itself in deep trouble. In fact, the most recent crises in East Asia and Russia have reminded us how rapidly and compellingly a financial crisis can erupt.

Theme 3