DEVELOPMENT ECONOMICS

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DEVELOPMENT ECONOMICS

Sponsored by a Grant TÁMOP-4.1.2-08/2/A/KMR-2009-0041 Course Material Developed by Department of Economics,

Faculty of Social Sciences, Eötvös Loránd University Budapest (ELTE) Department of Economics, Eötvös Loránd University Budapest

Institute of Economics, Hungarian Academy of Sciences Balassi Kiadó, Budapest

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Author: Katalin Szilágyi Supervised by Katalin Szilágyi

January 2011

Week 12

Financial openness and development Credit markets in developing countries

• Credit markets: imperfections

• Information is imperfect → strong institutions needed for contract enforcement

• Developing countries: institutions missing → information problems amplified

• Inefficient allocation of funds, high interest rates (spreads) etc.

Financial liberalization

• Does liberalization help?

• Trade openness ~ financial openness?

• Theory and empirics

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Outline

• Historical trends in financial openness

• Empirical evidence on financial liberalization

1. Historical trends Economic history

• Gold standard

• International system of fixed exchange rates (gold parity)

• Fully liberalized capital flows

• No independent monetary policies for individual countries

Bretton Woods

• Objective: promote international co-operation (trade)

• Fixed (but adjustable) exchange rates

• Full convertibility of national currencies for flow transactions, but capital controls prevail

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Capital controls

• Diverse controls

• Fears of hot money, bad experience from the 1930s-40s

• Governments eager to follow independent policies (interest rates), free flow of capital is a danger

International finance

• Current account imbalances are financed by international institutions (IMF), official loans and international reserves

• No private funds involved in international capital flows

Controversies

• Trade flows booming, free internationally ↔ constrained capital flows

• Recourse to trade credit

• Accounts for trade partners

• Financial transactions in trade disguise

• Financial restrictions create competitive disadvantages

End of fixed exchange rates

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• Free trade flows result in gradual financial liberalization

• Expectations of currency devaluations, speculative flows

• From 1970s: financial globalization

• Supported by IT development

Revealed preference?

• Historical trends: all country groups move towards more liberalized capital flows

• De jure and de facto

• Different pace

De jure openness

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De facto openness

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Exchange rate regime

2. Empirical evidence

Effect of financial liberalization

• On asset prices / rates of return

• Levels?

• Volatility?

• Correlation with the world?

• Sensitivity to world market (beta)?

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Rates of return (annual average)

Rates of return (standard deviation)

0,00 0,10 0,20 0,30 0,40 0,50 0,60 0,70 0,80 0,90 1,00

Argentina Brazil

Chile Colomb

ia Greece

India Indonesia

Jordan Korea

Malaysia Mexico

Nigeria Pakistan

Philippines Portugal

Taiwan Thailand

Turkey Venezuela

Zimbabwe Average

Pre Post

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Rates of return (correlation with the world)

Rates of return (beta)

-0,10 -0,05 0,00 0,05 0,10 0,15 0,20 0,25 0,30 0,35 0,40 0,45

Argentina Brazil

Chile Colomb

ia Greece

India Indonesia

Jordan Korea

Malaysia Mexico

Nigeria Pakistan

Taiwan Thailand

Turkey Venezuela

Zimbabwe Average

Pre Post

-0,60 -0,40 -0,20 0,00 0,20 0,40 0,60 0,80 1,00 1,20 1,40 1,60

Argentina Brazil

Chile Colomb

ia Greece

India Indonesia

Jordan Korea

Malaysia Mexico

Nigeria Pakistan

Taiwan Thailand

Turkey Venezuela

Zimbabwe Average

Pre Post

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Effect of financial liberalization

• Macroeconomic effects

• Growth?

• Output/consumption volatility?

• Macro policies?

• Institutions?

Growth effects

• Growth depends on other factors, too

• Controlling for usual suspects:

Growth regressions

• Results (five-year horizon):

Initial

Log(GDP) Gov/GDP

Secondary- School Enrollment

Population

Growth Log(Life)

Official

Liberalization Indicator

-0.0082 -0.0144 0.0004 -0.1911 0.0975

0.0097

0.0010 0.0131 0.0048 0.0774 0.0076 0.0020

• Very strong effect

• Mechanism?

• Capital accumulation? TFP?

• How to disentangle?

k t i t

i t

i i

k k t

i

Q X Lib

y

_, _ _,

 

_,₁₉₈₀

  

_,

 

_,

 

_, _

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Robustness

• To time horizon: yes

• To control variables: yes

• To fixed effects: yes

• To the concept of liberalization?

• de jure vs. de facto

• continuous vs. discrete

• self-defined vs. external sources Capital Account Openness

Official Liberalization Indicator 0.0097 0.0094 0.0120 0.0077 0.0115

Std. error 0.0020 0.0021 0.0022 0.0023 0.0022

IMF Capital Account Openness Indicator 0.0010 0.0020

Std. error 0.0017 0.0017

Quinn Capital Account Openness Indicator 0.0179

Std. error 0.0040

95 countries 76 countries

Problems

• Casual effect?

• Problem with endogenity

• Robustness?

• Problem with heterogenity

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Endogenity

• Financial liberalization is not an independent (exogenous) event

• Happens when growth prospects are good anyway

• Hard to handle

• Would need an instrument that correlated with financial liberalization but has no direct effect on growth prospects