Financial Openness and the Chinese Growth Experience Geert Bekaert Columbia University and NBER Campbell R. Harvey Duke University and NBER Christian T. Lundblad Indiana University China at the Crossroads Conference August 29-30, 2005

2 Financial Openness and China Plan 1.A Panel Perspective on China's Growth 2.Financial Openness and Growth 3.Empirical Results 4.Heterogeneity of Real Effects of Financial Openness on Growth

3 Financial Openness and China Historical perspective All real, per capita; not PPP-adjusted; from World Bank.

4 Financial Openness and China Growth experience

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6 Financial Openness and China Growth volatility

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8 Financial Openness and China Neoclassical Model  Barro (1991, 1992):   ≠ growth accounting GDP Growth Convergence Effect Steady state GDP determinants

9 Financial Openness and China Model Better measure to capture risk sharing benefits: idiosyncratic consumption growth volatility where g i,t+k = k-period average of consumption growth for country i, x i,t and z i,t = control variables i = country; w=world = conditional variance of

10 Financial Openness and China Historical perspective In late 1990s, Bekaert and Harvey begin a research program on financial openness  Time-lines constructed for “Official” equity market liberalizations ADR and Country Fund Launches Capital account openness Banking reforms Privatizations Capital Flows FDI activity (to do)

11 Chronologies also contain Important political events Macroeconomic events Information on institutions Currently, 56 emerging markets and over 400 pages of information Financial Openness and China Historical perspective

12 Financial Openness and China Historical perspective

13 Decreased cost of capital Changes might make country more sensitive to world shocks Impact on equity volatility not clear => Empirical work consistent with predictions (Bekaert and Harvey (2000), Henry (2000), Kim and Singal (2000)) Financial Openness and China What are the financial effects of openness?

14 If cost of capital decreases, more projects NPV>0 Investment increases Financial Openness and China What are the real effects of openness?

15 Financial Openness and China What are the real effects of openness? Financial Development Growth Financial Liberalization Relaxing Fin Constraints Investment Growth Opportunities Efficiency of Investment Cost of Capital

16 Liberalization implies consumption booms and inefficient investment (crisis literature) Liberalization may lead to reduced savings (endogenous growth literature) Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others) Financial Openness and China Sharply different views from literature…

17 Financial Openness and China Previous research Bekaert-Harvey-Lumsdaine (Journal of Financial Economics, 2002) –Dating the integration of world markets Bekaert-Harvey-Lundblad (Journal of Financial Economics, 2005) –GDP growth positively impacted by financial openness Bekaert-Harvey-Lundblad (Journal of International Money and Finance, 2006) –Growth volatility does not increase, on average, after opening Bekaert-Harvey-Lundblad-Siegel (Working paper, 2005) –Growth opportunities linked to growth

18 Financial Openness and China Previous research Bekaert-Harvey (Journal of Finance, 1995) –Model of time-varying world market integration (expected returns) Bekaert-Harvey (Journal of Financial Economics, 1997) –Model of time-varying world integration (expected returns; volatility) Bekaert-Harvey (Journal of Finance, 2000) –Financial openness impacts cost of capital, volatility, country’s sensitivity to world events Bekaert-Harvey-Lundblad (Journal of Development Economics, 2001) –Econometric framework developed for panel growth regressions Bekaert-Harvey-Lundblad (Journal of International Money and Finance, 2002) –Capital flows, liberalization and the real economy

19 Financial Openness and China Financial openness

20 Financial Openness and China Financial openness

21 Financial Openness and China Financial openness

22 Financial Openness and China Results

23 Financial Openness and China Results

24 Financial Openness and China Results

25 Financial Openness and China Components

26 Financial Openness and China Financial development

27 Financial Openness and China Decomposing the growth regression

28 Financial Openness and China Decomposing the growth regression

29 Financial Openness and China Components

30 Financial Openness and China Components

31 Financial Openness and China Components

32 Financial Openness and China Growth, Investment, and Total Factor Productivity

33 Financial Openness and China Adding investment to growth regression  Reduces coefficient on private credit to GDP  Significant in consumption but not in GDP growth regressions  Raises predicted GDP growth by 0.4%

34 Financial Openness and China Growth volatility

35 Financial Openness and China Growth volatility

36 Financial Openness and China Growth volatility

37 Financial Openness and China Why do countries respond differently to openness?

38 Financial Openness and China Why do countries respond differently to openness?

39 Financial Openness and China Financial development

40 Financial Openness and China Why do countries respond differently to openness?

41 Financial Openness and China Financial development

42 Financial Openness and China Why do countries respond differently to openness?

43 Financial Openness and China Why do countries respond differently to openness?

44 Financial Openness and China Why do countries respond differently to openness?

45 Financial Openness and China Country Risk

46 Financial Openness and China Why do countries respond differently to openness?

47 Financial Openness and China Country Risk

48 Financial Openness and China Conclusions  China’s growth experience cannot be explained by standard growth models  Using standard growth determinants, China’s predicted growth in 2003 was 2.57% (versus 2.00% in 1980)  China is lower than average on: quality of institutions stock market development capital account openness

49 Financial Openness and China Further research  Embed quality of institutions; finer measures of financial development in growth decompositions  Study factor productivity growth?  Study determinants of GDP per capita? (see Roll and Talbot, 2004)

50 Financial Openness and China Financial development

51 Financial Openness and China Financial development

52 Financial Openness and China Financial development

53 Financial Openness and China Country Risk

54 Financial Openness and China Country Risk

55 Financial Openness and China Country Risk

56 Financial Openness and China Country Risk

57 Financial Openness and China Neoclassical Model Consider the Solow (1956) model:  Y=  A +  K + (1-  )  L where:  Y = change in output per worker  A = change in total factor productivity  K = change in capital stock  L = change in labor stock  elasticity

58 Financial Openness and China Components

59 Financial Openness and China Components

60 Financial Openness and China Components

61 Financial Openness and China Components