The Effect of Financial Globalization on Monetary Policy Discipline: The Evidence from 22 Developing Countries

The literature on the benefits and costs of financial globalization for developing countries has exploded in recent years. There seems to be a consensus that financial globalization has had a "discipline effect" on monetary policy, because it has reduced the returns from using monetary policy to stabilize the output. As a result, monetary policy over recent years has placed more emphasis on stabilizing inflation, leading to lower inflation and higher output stability. However, this consensus has not been accompanied by convincing empirical evidence that such a relationship exists. In this article, we study the relationship between financial globalization and monetary policy regulation in a sample of 22 developing countries over the period of 1990 to 2006 using panel data approach. Our results confirm a negative relationship between financial openness and median inflation rates. It therefore appears to be the case that financial openness is one of a number of characteristics of those countries exhibiting monetary policy stability. The result is consistent with those in Kose et al. (2006) who concluded that the primary benefits of financial globalization may precisely be "collateral benefits" such as the possibility of enhanced monetary policy outcomes. However, the recent "sub-prime" financial turmoil has highlighted the possibility of the increased sophistication as a result of financial globalization. As asset bundles became more diversified, it appeared to be more difficult to assess the underlying asset quality of investment positions. The crisis does raise the question of whether losses incurred from investment vehicles increasingly used in the globalization period will force investors to avoid these types of vehicles in the future, and in the meantime lower the pace of financial globalization. Examining this issue is beyond the scope of this study and awaits future research.