NBER WORKING PAPER SERIES INTERNATIONAL FINANCIAL INTEGRATION AND ECONOMIC GROWTH. Hali J. Edison Ross Levine Luca Ricci Torsten Sløk - PDF

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NBER WORKING PAPER SERIES INTERNATIONAL FINANCIAL INTEGRATION AND ECONOMIC GROWTH Hali J. Edison Ross Levine Luca Ricci Torsten Sløk Working Paper NATIONAL BUREAU

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NBER WORKING PAPER SERIES INTERNATIONAL FINANCIAL INTEGRATION AND ECONOMIC GROWTH Hali J. Edison Ross Levine Luca Ricci Torsten Sløk Working Paper NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA September 2002 The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research by Hali J. Edison, Ross Levine, Luca Ricci, and Torsten Sløk. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is given to the source. International Financial Integration and Economic Growth Hali J. Edison, Ross Levine, Luca Ricci and Torsten Sløk NBER Working Paper No September 2002 JEL No. F3, O4, O16 ABSTRACT This paper uses new data and new econometric techniques to investigate the impact of international financial integration on economic growth and also to assess whether this relationship depends on the level of economic development, financial development, legal system development, government corruption, and macroeconomic policies. Using a wide array of measures of international financial integration on 57 countries and an assortment of statistical methodologies, we are unable to reject the null hypothesis that international financial integration does not accelerate economic growth even when controlling for particular economic, financial, institutional, and policy characteristics. Hali J. Edison Ross Levine International Monetary Fund Finance Department Washington, DC University of Minnesota Minneapolis, MN Luca Ricci Torsten Sløk International Monetary Fund International Monetary Fund Washington, DC Washington, DC 20431 I. Introduction Theory provides conflicting predictions about the growth effects of international financial integration (IFI), i.e., the degree to which an economy does not restrict cross-border transactions. According to some theories, IFI facilitates risk-sharing and thereby enhances production specialization, capital allocation, and economic growth (Obstfeld, 1994; Acemoglu and Zilibotti, 1997). Further, in the standard neoclassical growth model, IFI eases the flow of capital to capitalscarce countries with positive output effects. Also, IFI may enhance the functioning of domestic financial systems, through the intensification of competition and the importation of financial services, with positive growth effects (Klein and Olivei, 2000; Levine, 2001). On the other hand, IFI in the presence of pre-existing distortions can actually retard growth. 1 Boyd and Smith (1992), for instance, show that IFI in countries with weak institutions and policies e.g., weak financial and legal systems may actually induce a capital outflow from capital-scarce countries to capitalabundant countries with better institutions. Thus, some theories predict that international financial integration will promote growth only in countries with sound institutions and good policies. Although theoretical disputes and the concomitant policy debate over the growth effects of IFI have produced a burgeoning empirical literature, resolving this issue is complicated by the difficulty in measuring IFI. Countries impose a complex array of price and quantity controls on a broad assortment of financial transactions. Thus, researchers face enormous hurdles in measuring cross-country differences in the nature, intensity, and effectiveness of barriers to international capital flows (Eichengreen, 2001). 1 To paraphrase Eichengreen s (2001, p.1) insightful literature review, there are innumerable constellations of distortions for which liberalization of international capital controls will hurt resource allocation and growth. For example, in the presence of trade distortions, capital account liberalization may induce capital inflows to sectors in which the country has a comparative disadvantage. 1 In practice, empirical analyses use either (i) proxies for government restrictions on capital flows or (ii) measures of actual international capital flows. The International Monetary Fund s (IMF) IMF-restriction measure is the most commonly used proxy of government restrictions on international financial transactions. It classifies countries on an annual basis by the presence or absence of restrictions, i.e., it is a zero-one dummy variable. Quinn (1997) attempts to improve upon the IMF-restriction measure by reading through the IMF s narrative descriptions of capital account restrictions and assigning scores of the intensity of capital restrictions. Unfortunately, the Quinn (1997) measure is only available for intermittent years for most countries (1958, 1973, 1982, and 1988). The advantage of the IMF-Restriction and Quinn (1997) measures is that they proxy directly for government impediments. The disadvantage of both measures, as noted above, stems from the difficulty in accurately gauging the magnitude and effectiveness of government restrictions. Empirical studies also use measures of actual international capital flows to proxy for international financial openness. The assumption is that more capital flows as a share of Gross Domestic Product (GDP) are a signal of greater IFI. The advantage of these measures is that they are widely available and they are not subjective measures of capital restrictions. A disadvantage is that many factors influence capital flows. Indeed, growth may influence capital flows and policy changes may influence both growth and capital flows, producing a spurious, positive relationship between growth and capital flows, and growth may affect capital flows. This highlights the need to account for possible endogeneity in assessing the growth IFI-relationship. Empirical evidence yields conflicting conclusions about the growth effects of IFI. Grilli and Milesi-Ferretti (1995), Rodrik (1998), and Kraay (1998) find no link between economic growth and the IMF-restriction measure. In contrast, Edwards (2001) finds that the IMF-restriction measure is 2 negatively associated with growth in rich countries but positively associated with growth in poor countries. He thus argues that good institutions are necessary to enjoy the positive growth effects of IFI. Arteta, Eichengreen, and Wyplosz (2001), however, argue that Edwards s results are not robust to small changes in the econometric specification. While Quinn (1997) finds that his measure of capital account openness is positively linked with growth, Arteta, Eichengreen, and Wyplosz (2001) and Kraay (1998) find these results are not robust. Finally, while some studies find that foreign direct investment (FDI) inflows are positively associated with economic growth when countries are sufficiently rich (Blomstrom, Lipsey, and Zejan, 1994), educated (Borenzstein, De Gregorio, and Lee, 1998), or financially developed (Alfaro et al., 2001), Carkovic and Levine (2002) find that these results are not robust to controlling for simultaneity bias. 2 In light of the current state of the literature on the growth effects of IFI, we contribute to existing empirical analyses in four ways. First, we examine an extensive array of IFI indicators. We examine the IMF-restriction measure and the Quinn measure of capital account restrictions. Furthermore, we examine various measures of capital flows: FDI, portfolio, and total capital flows. Moreover, we consider measures of just capital inflows as well as measures of total capital flows (inflows plus outflows) to proxy for IFI because openness is defined both in terms of receiving foreign capital and in terms of domestic residents having the ability to diversity their investments abroad. We examine a wide array of IFI proxies because each indicator has advantages and disadvantages. Second, we examine two new measures of IFI. Lane and Milesi-Ferretti (2002) carefully compute the accumulated stock of foreign assets and liabilities for an extensive sample of countries. 2 For more detailed literature reviews of cross-country studies of the causes and effects of IFI, see Eichengreen (2001) and Edison, Klein, Ricci, and Sløk (2002). For a review of country-specific experiences with IFI, see Cooper (1999). 3 Since we want to measure the average level of openness over an extended period of time, these stock measures provide a useful additional indicator. Furthermore, these stock measures are less sensitive to short-run fluctuations in capital flows associated with factors that are unrelated to IFI, and may therefore provide a more accurate indicator of IFI than capital flow measures. As proxies for IFI, we examine both the accumulated stock of liabilities (as a share of GDP) and the accumulated stock of liabilities and assets (as a share of GDP). Also, we break down the accumulated stocks of financial assets and liabilities into FDI, portfolio, and total financial claims in assessing the links between economic growth and a wide assortment of IFI indicators. Thus, we add these additional IFI indicators to the empirical examination of growth and international financial integration. Third, since theory and some past empirical evidence suggest that IFI will only have positive growth effects under particular institutional and policy regimes, we examine an extensive array of interaction terms. Specifically, we examine whether IFI is positively associated with growth when countries have well-developed banks, well-developed stock markets, well functioning legal systems that protect the rule of law, low levels of government corruption, sufficiently high levels of real per capita GDP, high levels of educational attainment, prudent fiscal balances, and low inflation rates. Thus, we search for economic, financial, institutional, and policy conditions under which IFI boosts growth. Fourth, we use newly developed panel techniques that control for (i) simultaneity bias, (ii) the bias induced by the standard practice of including lagged dependent variables in growth regressions, and (iii) the bias created by the omission of country-specific effects in empirical studies of the IFI-growth relationship. Since each of these econometric biases is a serious concern in assessing the growth-ifi nexus, applying panel techniques enhances the confidence we can have in 4 the empirical results. Furthermore, the panel approach allows us to exploit the time-series dimension of the data instead of using purely cross-sectional estimators. Before beginning the analyses, it is important to mention a related strand of the literature on IFI. We examine the relationship between broad measures of IFI and growth. Other researchers focus instead on a much narrower issue: restrictions on foreign participation in domestic equity markets. Levine and Zervos (1998b) construct indicators of restrictions on equity transactions by foreigners. They show that liberalizing restrictions boosts equity market liquidity. Henry (2000a,b) extends these data and shows that liberalizing restrictions on foreign equity flows boosts domestic stock prices and domestic investment. Bekaert, Harvey, and Lundblad (2001) go farther and show that easing restrictions on foreign participation in domestic stock exchanges accelerates economic growth. While it is valuable to examine the impact of liberalizing restrictions on foreign activity in domestic stock markets, it is also valuable to study whether international financial integration in general has an impact on economic growth under particular economic, financial, institutional, and policy environments. This paper examine the relationship between economic growth and broad measures of IFI for large cross-section of countries while recognizing the value of studies that focus on specific barriers to particular categories of international financial transactions. The remainder of the paper is organized as follows. Section II discusses the data and presents summary statistics. Section III describes the econometric methodology while Section IV gives the results. Section V concludes. II. Data and Summary Statistics This paper uses new data to examine the growth effects of international financial integration (IFI) and to assess whether the growth-ifi relationship depends on the level of economic 5 development, financial development, institutional development, or macroeconomic policies. Given existing barriers to measuring IFI confidently for a broad cross-section of countries, this paper seeks to improve the analysis of IFI and growth by (i) assessing a broader array of IFI indicators than any previous study and (ii) using a new type of financial openness indicator. The new indicators are based on the Lane and Milesi-Ferretti (2002) measures of the accumulated stock of foreign assets and liabilities. A. Data on International Financial Integration 3 IMF-Restriction: The IMF-Restriction measure equals one in years where there are restrictions on capital account transactions and zero in years where the are no restrictions on these external transactions. The data are from the IMF s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER) (line E.2). When conducting regressions averaged over, for example, the period, we follow the literature and average the IMF-Restriction measure over the entire period and use this to measure the average level of openness during the period (e.g., see Grilli and Milesi-Ferretti, 1995; Rodrik, 1998; and Klein and Olivei, 2001). 4 As emphasized above, the IMF-Restriction measure may not accurately capture the magnitude and effectiveness of restrictions on capital flows. Quinn measure: Based on descriptive information in the in the AREAER, Quinn (1997) assigns scores associated of the intensity of official restrictions on both capital inflows and outflows. This measure attempts to improve upon the IMF-Restriction measure by providing 3 The Data Appendix Data provides more detailed information on the variables used in this paper. 4 In 1997, however, there was structural break in the AREAER documentation of capital controls. No longer are countries categorized as having open or restricted capital accounts. Since 1997, information is provided on thirteen separate categories of capital flows, including a distinction between restrictions on inflows and outflows. Because of the structural break, we only use information on IMF-Restriction through information about the magnitude of restrictions, rather than simply designating countries as closed or open. The Quinn measure, however, is a particularly subjective measure. Also, it is highly correlated (0.9) with the IMF-Restriction measure (Edison, Klein, Ricci, and Sløk, 2002). Moreover, for non-oecd countries, it is only available for two years (1982, 1988) over the sample period that we examine. Thus, we cannot use the Quinn measure in our panel estimates. Since the use of panel estimates to reduce statistical biases is an important contribution of this paper, we confirm our pure cross-country, ordinary least squares (OLS) results using the Quinn measure but do not report these results in the tables. Stock of Capital Flows accumulates FDI and portfolio inflows and outflows as a share of GDP. Thus, it is the stock of a nation s foreign assets plus liabilities as a share of GDP (Lane and Milesi-Ferretti, 2002). We examine assets plus liabilities because theoretical concepts of openness include both (i) the ability of foreigners to invest in a country and (ii) the ability of residents to invest abroad. We have also examined the components of the Stock of Capital Flows measures, i.e., the accumulated stock of FDI and portfolio flows respectively. Since we obtain the same results with these components, we focus on the stock of total capital inflows and outflows. This is the first time these stock measures of IFI have been used to study economic growth. The advantage of the stock measure is that it accumulates flows over a long period. Thus, unlike standard capital flow measures, the stock measure does not vary very much with short-run changes in the political and policy climate. Flow of Capital equals FDI and portfolio inflows and outflows as a share of GDP. Thus, it is total capital inflows plus outflows divided by GDP. Kraay (1998) used this indicator to measure capital account openness. As noted, it is important to measure both inflows and outflows in creating an IFI proxy. As with the Stock of Capital Flows measure, we have examined the 7 individual components of the Flow of Capital indicator. Specifically, we examined FDI and portfolio flows individually. Again, we obtain similar results with the sub-components, so we simply report the results with total capital flows. While we recognize the problems associated with using the Flow of Capital indicator, we include it to provide as comprehensive an empirical assessment of IFI and growth as possible. Stock of Capital Inflows accumulates FDI and portfolio inflows as a share of GDP. Thus, it is the stock of a nation s foreign liabilities as a share of GDP (Lane and Milesi-Ferretti, 2002). Unlike the Stock of Capital Flows variable defined above, the Stock of Capital Inflows indicator excludes capital outflows. We use the Stock of Capital Inflows measure since some consider capital inflows to be particularly important for economic growth in developing countries. We have also examined the components of the Stock of Capital Inflows measures, i.e., the stock of FDI and portfolio liabilities respectively, but only report the results on the stock of total capital inflows because we get similar results on the components. Thus, we add this new measure of capital account openness to the study of growth and IFI. Inflows of Capital equals FDI and portfolio inflows as a share of GDP. Unlike Flows of Capital, Inflows of Capital exclude capital outflows. Again, we include this variable since some discussions emphasize the growth effects of capital inflows. While none of these indicators may fully capture the concept of international financial integration, we use a collection of indicators with different pros and cons to assess the relationship between economic growth and financial openness. B. Data on Other Variables To assess the relationship between economic growth and IFI we control for other potential growth determinants and also examine whether IFI influences growth only under particular economic, financial, institutional, and policy environments (Levine and Renelt, 1992). Growth 8 equals real per capita GDP growth, which is computed over the period of analysis. Thus, in the pure cross-country regressions and in the Table 1 summary statistics Growth is computed over the period. As is common in cross-country growth regressions, we control for initial conditions. Initial Income equals the logarithm of real per capita GDP in the initial year of the period under consideration, and Initial Schooling equals the logarithm of the average years of secondary schooling in the initial year of the period under consideration. We examine both financial intermediary development and the liquidity of the domestic stock market. Private Credit equals the logarithm of credit to the private sector by deposit money banks and other financial institutions as a share of GDP, while Stock Activity equals the logarithm of the total value of domestic stock transactions on domestic exchanges as a share of GDP. We use logarithms to reduce the influence of large outliers of the finance variables. Including the finance variables in levels still produces a positive relationship between financial development and growth (Levine and Zervos, 1998a). We also control for macroeconomic policies. Inflation equals the growth rate of the consumer price index and Government Balance equals the governments fiscal balance divided by GDP, with positive values signifying a surplus and negative values a fiscal deficit. Finally, we examine the level of institutional development, as measured by the law and order tradition (Law and Order Tradition
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