Financial Deepening and International Monetary Stability

Abstract

Recent discussions at the IMF and the G-20 on strengthening the international monetary system have emphasized, among other efforts, increasing the financial depth of emerging markets. Such deepening is widely believed to confer important stability benefits, helping countries limit swings in asset prices, find alternative sources of funding, and attenuate the need for reserve accumulation. This paper seeks to shed light on the role of financial deepening in promoting the stability of the system as a whole. A simple balance sheet metric of financial depth shows a growing divergence in the financial depth of advanced versus emerging markets, pointing to scope for catch-up. But catch-up has implications for global imbalances, insofar as international adjustment requires slower growth of domestic claims in advanced deficit countries (slower credit growth lowers domestic demand) and faster growth in surplus economies and emerging markets (which would raise domestic demand). Deepening is also related to crisis incidence and costs. Crisis risks and costs are high in the initial stages of deepening, during which policymakers tend to build reserve buffers, constrain capital mobility, and limit exchange rate flexibility. In later stages, alongside flexible exchange rates, open capital accounts and smaller reserve buffers, crisis incidence is found to decline. Although financial deepening can contribute to lowering imbalances and crisis incidence and costs, it is a long-term process. Therefore, it remains crucial to make progress in the near term to strengthen the international monetary system, including building a strong global financial safety net and developing a framework for coping with capital flows.