Electronic copy available at: http://ssrn.com/abstract=1358574 Financial Openness and Productivity Geert Bekaert Columbia University, New York, NY 10027 USA National Bureau of Economic Research, Cambridge, MA 02138 USA Campbell R. Harvey Duke University, Durham, NC 27708 USA National Bureau of Economic Research, Cambridge, MA 02138 USA Christian Lundblad 1 University of North Carolina, Chapel Hill, NC 27599 USA May 2010 Summary. – Financial openness is often associated with higher rates of economic growth. We show that the impact of openness on factor productivity growth is more important than the effect on capital growth. This explains why the growth effects of liberalization appear to be largely permanent, not temporary. We attribute these permanent liberalization effects to the role financial openness plays in stock market and banking sector development, and to changes in the quality of institutions. We find some indirect evidence of higher investment efficiency post- liberalization. We also document threshold effects: countries that are more financially developed or have higher quality of institutions experience larger productivity growth responses. Finally, we show that the growth boost from openness outweighs the detrimental loss in growth from global or regional banking crises. Key words – globalization, financial liberalization, economic growth, productivity, crisis
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Electronic copy available at: http://ssrn.com/abstract=1358574
Financial Openness and Productivity
Geert Bekaert
Columbia University, New York, NY 10027 USA
National Bureau of Economic Research, Cambridge, MA 02138 USA
Campbell R. Harvey
Duke University, Durham, NC 27708 USA
National Bureau of Economic Research, Cambridge, MA 02138 USA
Christian Lundblad1
University of North Carolina, Chapel Hill, NC 27599 USA
May 2010
Summary. – Financial openness is often associated with higher rates of economic growth. Weshow that the impact of openness on factor productivity growth is more important than theeffect on capital growth. This explains why the growth effects of liberalization appear to belargely permanent, not temporary. We attribute these permanent liberalization effects to therole financial openness plays in stock market and banking sector development, and to changes inthe quality of institutions. We find some indirect evidence of higher investment efficiency post-liberalization. We also document threshold effects: countries that are more financially developedor have higher quality of institutions experience larger productivity growth responses. Finally,we show that the growth boost from openness outweighs the detrimental loss in growth fromglobal or regional banking crises.
Key words – globalization, financial liberalization, economic growth, productivity, crisis
Electronic copy available at: http://ssrn.com/abstract=1358574
1 INTRODUCTION
Recent evidence strongly suggests a link between financial openness and economic
growth. For example, Bekaert, Harvey and Lundblad (2005) and Quinn and Toyoda
(2008) document strong growth effects. However, Rodrik (1998) and Edison, Levine,
Ricci, and Slok (2002) find weak effects and a survey paper by Prasad, Rogoff, Wei, and
Kose (2009) calls the collective evidence “mixed.” This debate has largely been settled
by two pieces of evidence. First, Quinn and Toyoda (2008) show that the “weak effects”
are largely driven by measurement error in the financial openness variable used in these
studies. Second, some new micro level studies, Gupta and Yuan (2009) at the industry
level and Mitton (2006) at the firm level, confirm the positive growth effects of stock
market liberalization and find them to be stronger than in Bekaert, Harvey, and Lundblad
(2005).
Nevertheless, this evidence generates an important issue. In the standard “neo-
classical” model, a capital market liberalization lowers the cost of capital, thereby in-
ducing additional investment and a temporary growth response. However, the decrease in
the cost of capital appears rather modest (Bekaert and Harvey (2000), Henry (2000)), and
the associated increase in investment is small relative to the large GDP growth increment
(Henry (2003)). Of course, financial openness may also directly affect factor productivity,
for example, by spurring financial development, promoting better corporate governance,
or signaling higher quality governments (Rajan and Zingales (2003)). Gourinchas and
Jeanne (2006) argue that examining the productivity effects of international financial in-
tegration is far more important than considering its investment growth effects, as the
latter have little chance of helping developing countries close the development gap. This
is what we set out to do in this article.
Our first task is to decompose the per capita output growth effect into two channels:
changes in factor productivity and investment growth. We find that factor productivity is
the more important channel. Our work thereby fills a gap in the literature regarding the
determinants of factor productivity growth. Much of the extant literature focuses on the
beneficial effects of financial development, but part of that link may really be due to finan-
cial openness (see Bekaert, Harvey, Lundblad and Siegel (2007) for a related argument).2
1
Electronic copy available at: http://ssrn.com/abstract=1358574
Our results also complement the results in Borenstein et al. (1998), which document that
Foreign Direct Investment improves factor productivity. We also provide a new analysis
of which part of the growth response is temporary and what part is permanent. To shed
more light on the sources of the permanent effect, we examine the effects of financial liber-
alization on future financial development and the quality of institutions. In related work,
Ferreira and Matos (2008) provide evidence that foreign institutional investors promote
improved corporate governance. We find that financial openness enhances the develop-
ment and efficiency of the stock market, the quality of institutions, and macroeconomic
policies, but the results are not fully robust across specifications.
A simple mechanism for financial openness to affect productivity is that it improves
domestic allocative efficiency. For example, in Obstfeld’s (1994) model, openness allows
countries to more efficiently share risk and invest in the higher expected return, riskier
projects. Again, the existing literature has focused on financial development, see e.g.
Fisman and Love (2004) and Wurgler (2000), but not on financial openness. Galindo,
Schianterelli and Weiss (2007) show that domestic financial liberalization improves the
efficiency of investment allocation. Our results suggest that investment is more sensitive
to global growth opportunities in countries that are open to foreign investors. We are
therefore able to generalize the results in, for instance, Chari and Henry (2008), who
show that firm-specific investment in a sample of five countries is correlated with changes
in growth opportunities after stock market liberalization.
We then go on to conduct an extensive interaction analysis examining on which local
conditions lead to the largest investment growth and/or factor productivity growth re-
sponses. This evidence provides a new perspective on the existing work on the threshold
effects in the relation between financial integration and growth (see Bekaert, Harvey and
Lundblad (2001, 2005), Edwards (2001), Klein (2003), Prasad et al. (2009)). We find that
both financial development and the quality of institutions produce positive interaction ef-
fects. This result is reminiscent of recent work on the effects of FDI on economic growth
by Alfaro, Chanda, Kalemli-Ozcan, and Sayek (2004) and on FDI and factor productivity
by Alfaro, Kalemli-Ozcan, and Sayek (2009), also showing positive interaction effects with
the development of local financial markets.
Finally, one often hears the argument that globalization makes countries more suscep-
2
tible to financial crises.3 We therefore directly examine the interaction between crises and
financial liberalization. Ranciere, Tornell, and Westermann (2008) argue that a banking
and currency crisis, such as the Asian crisis in 1997, may be the price to pay for the longer-
term benefits of financial openness. We find that financial openness does not significantly
increase the incidence of crises and that the output loss of a crisis is far outweighed by
the output gain of financial liberalization.
Our results are of interest to the wider debate about the pros and cons of globalization.
Stiglitz (2010) used the recent global crisis to reiterate that the existence of various mar-
ket imperfections (information asymmetry, non-convex technologies, incomplete markets)
may make full global market integration undesirable. However, the conclusions from this
post-Washington consensus (see Fine (2002)) are based on theoretical models, whereas we
report robust empirical results that seem to at least challenge the policy implications of
the new theories. Another important issue in the debate is the effect of financial openness
on inequality. Wade (2002) argues that globalization may well have contributed to more
inequality within and across countries, and has not served to close the income gap. Be-
cause increases in factor productivity have, at the very least, the potential to contribute
to closing the income gap, we provide some simple empirical evidence regarding this issue
in the conclusion. Financial openness has indeed reduced the income gap between rich
and poor liberalizing countries; but, in fact, overall cross-sectional income dispersion has
increased.
The paper is organized as follows. In the second section, we introduce the data and
the econometric methods used in the study. We then present evidence on the link between
financial openness and economic growth, decomposing the growth effect into investment
growth and factor productivity in Section 3. Section 4 investigates threshold effects. Sec-
tion 5 focuses on the interaction between crises and financial openness. Some concluding
remarks are offered in the final section.
2 OUTPUT GROWTH AND FINANCIAL
LIBERALIZATION
(a) Data
3
Our data, spanning the 1980-2006 period and 96 countries, are drawn from a number of
sources detailed in Appendix Table 1. Some summary statistics are provided in Appendix
Table 2. While most variables do not require further explanation here, it is important to
discuss how we measure capital stock and factor productivity growth. The growth in the
capital stock is equal to aggregate real investment less depreciation in the capital stock
divided by the previous year’s capital stock. We build per capita physical capital stocks
using the method described in King and Levine (1993b). We derive an initial estimate
of the capital stock for 1960, assuming each country is at its steady state capital-output
ratio at that time. Then, we use the aggregate real investment series and the perpetual
inventory method with a depreciation rate of 7% to compute the capital stock in later
years. Total factor productivity growth is constructed as in Beck, Levine, and Loayza
(2000). Assuming a capital share of 0.3 for all countries, we calculate productivity growth
as the difference between the GDP growth rate and 0.3 times the capital stock growth
rate. Several articles have criticized the assumption of a country invariant capital share
(see, for instance, Gollin (2002)). We therefore consider an alternative computation which
uses the country-specific capital shares for the manufacturing sector reported in Ortega
and Rodriguez (2006), but re-scaled to average 0.35 across countries.
We employ several measures of financial openness. First, our capital market openness
variable uses data from the IMF’s Annual Report on Exchange Arrangement and Exchange
Restrictions. There are six categories of restrictions. If any restriction is in place, the
standard indicator takes a value of zero suggesting the capital account is closed. Because
of its coarseness, this variable has been discredited in the literature, see e.g. Eichengreen
(2001). We instead employ Quinn’s (1997) measure of capital account openness (see also
Quinn and Toyoda (2008)). While relying on the same IMF data, Quinn scores each of
these restrictions, separately for capital payments and receipts, on a scale of 0 to 2 (0.5
increments), and then adds the two. Quinn’s system investigates the need for official
approval, the likelihood it is granted, and the presence of taxes. It therefore measures the
degree to which the capital account is open. The measure is available for 78 of our 96
countries.
Second, to measure equity market openness, we use the official financial openness mea-
sure based on Bekaert and Harvey’s (2005) Chronology of Important Economic, Financial
4
and Political Events in Emerging Markets. The official liberalization measure is an indi-
cator variable that takes the value of one once a country allows foreigners to transact in
the local equity market. The official equity market liberalization variable is available for
all 96 countries.
Last, we consider an additional measure of equity market openness, proposed by
Bekaert (1995) and Edison and Warnock (2003), to explore the robustness of our mea-
sured effects to the dating of financial liberalization. The equity market openness measure
is a continuous variable that reflects the ratio of market capitalization available to foreign
investors divided by the total market capitalization of all domestically listed firms. For
this measure, a value of zero means the market is segmented to foreigners and a value of
one means that the entire market capitalization is available to foreign investors.
(b) Econometric framework
Define yi,t as the log growth rate in per capita real GDP, capital stock, or total factor
productivity for country i. Our dependent variable is growth over five years:
yi,t+5,5 =1
5
5∑j=1
yi,t+j i = 1, . . . , N (1)
where N is the number of countries in our sample. Our main panel regression is specified
2On the link between productivity and financial development, see Jeong and Townsend (2007) who
show that total factor productivity growth can come about by financial deepening and an expansion
of credit (using data from Thailand); Hsieh and Klenow (2009) who provide micro evidence on capital
mis-allocation in China and India relative to the U.S.; Levine and Zervos (1998) who show that stock
market development improves factor productivity; and Peress (2008) who proposes a model that links
financial development and technological progress.
3See, for instance, Kaminsky and Reinhart (1999).
4See also Eichengreen (2001). Unlike Rodrik’s claim, these results remain robust to the inclusion
of institutional quality variables, as we show below. Henry (2007) discusses some other problems with
Rodrik’s empirical approach.
5In the presence of Wacziarg and Welch’s trade liberalization indicator, the capital account and equity
openness effects are somewhat smaller, but are still near 1% per annum and highly statistically significant.
The trade liberalization effect itself is statistically significant and around 50 to 70 basis points per annum
in magnitude for GDP, capital stock, or total factor productivity growth.
6For our full 96 country sample, the inclusion of both country and time indicators leads to a poorly
behaved variance-covariance matrix given the dimensionality of the system. For this reason, we employ
instead world GDP growth as an alternative control variable for temporal effects.
7We do not report the results to conserve space and because the use of the measure restricts our
sample of countries.
8These concerns are therefore much more valid when de facto, as opposed to de jure, financial inte-
gration is considered: capital may flow to “productive” countries.
9We also consider an alternative probit specification just for those countries that either liberalize in-
sample or never liberalize. This specification is more in line with traditional “treatment” interpretations
used in this literature, and yields similar results.
10Griffin, Kelly, and Nardari (2008) discuss how time-variation in this measure is sometimes difficult to
interpret. In contrast, Bailey, Bae, and Mao (2006) show that financial openness improves the information
environment. For instance, analyst coverage and value-added by analysts increase with openness, partly
due to the increased presence and activity of foreign analysts.
11For example, Desai and Moel (2008) discuss a particular case where the government of the Czech
Republic compensated a foreign investment unit following significant losses associated with poor corporate
governance. More generally, Leuz, Lins, and Warnock (2009) find that foreigners invest less in firms that
26
reside in countries with poor outsider protection, disclosure, and governance. Choi, Lee, and Park (2007)
provide a specific example of a foreign-financed activist fund that directly pushes corporate governance
reforms in Korea.
12Bonfiglioli (2008) also finds a positive link between private credit to GDP and crises; she also finds
a limited role for financial liberalization in explaining crises in developed countries.
27
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