Trade Liberalization and the Politics of Financial Development Matías Braun, UCLA Claudio Raddatz, World Bank LAFN Dec 3 rd,2004

Private Credit / GDP Rank early-1970s Private Credit / GDP Rank late-1990s Motivation Non-Trade Liberalizers Trade Liberalizers Trade Liberalization is a shock to the persistence of FD We know something about why ZAF has always had a more developed financial system than MEX. We know something about why ZAF has always had a more developed financial system than MEX. However, we know very little about why BOL started out like MEX but is now like ZAF. However, we know very little about why BOL started out like MEX but is now like ZAF. We propose a Political Economy framework to understand why -despite the fact that FD seems beneficial on average and policies do matter- not all countries are developed. We use Trade liberalization as a shock to the political economy equilibrium. We propose a Political Economy framework to understand why -despite the fact that FD seems beneficial on average and policies do matter- not all countries are developed. We use Trade liberalization as a shock to the political economy equilibrium.

Political economy equilibrium based on the effect of FD on product market competition Political economy equilibrium based on the effect of FD on product market competition FD enhances competition FD enhances competition Effect is heterogeneous across industries: Effect is heterogeneous across industries:  Promoters and Opponents Relative strength determines equilibrium Relative strength determines equilibrium Trade Liberalization as a shock Trade Liberalization as a shock Test: Do increases in the relative strength of promoters translates into subsequent increases in FD?…. Test: Do increases in the relative strength of promoters translates into subsequent increases in FD?…. Motivation

Preview …Yes. Countries where trade liberalization strengthens promoters of financial development vis-à-vis opponents subsequently develop their financial systems more. …Yes. Countries where trade liberalization strengthens promoters of financial development vis-à-vis opponents subsequently develop their financial systems more. Empirical Approach Step 1: Identify Promoters and Opponents of FD Step 2: Measure shock to relative Strength of groups Step 3: Do changes in relative strength predict changes in FD?

Methodology, Step 1 Promoters and Opponents of FD One reason for conflict to emerge is that FD enhances competition. One reason for conflict to emerge is that FD enhances competition.  We measure monopoly rents with the Price-Cost Margin (PCM)  PCMs are positively related with concentration across industries  Average PCMs decline with FD across countries Incumbents weight the benefits of increased availability of external funds and the costs of entry. The trade-off differs across industries. Incumbents weight the benefits of increased availability of external funds and the costs of entry. The trade-off differs across industries.  can measure each industry’s PCM sensitivity to FD and determine (relative) promoters and opponents: cross-country identification with legal origins instrumenting for FD.

Methodology, Step 1 Promoters and Opponents of FD The ranking of industries is almost the same when measuring promoters/opponents with the effect of FD on average firm size Textiles Non-basic Chemicals Promoters tend to: - Invest a higher fraction of flows - Be less tangible - Old promoters have higher external finance requirements relative to young promoters when compared to opponents - Have lower natural entry/exit

Methodology, Step 2 Trade Liberalization Effect on Strength of Promoters Trade Liberalization is a discrete event… …that affects the overall level of PCMs… …and the relative PCM of Promoters v. Opponents differently across countries. Where Promoters are Strengthened Where Promoters are Weakened Strength Promoters Trade Liberalization Event Time

Methodology, Step 3 Trade Liberalization Event Time Private Credit / GDP Specification:

Results The Sample

Results Main Result Where promoters are strengthened relative to opponents the financial system subsequently develops. This is not related to changes in the demand for external finance. The result is robust to: -Event-Study Technicalities - Firm size measure to id. Promoters v. Opponents - Effect of pcGDP, Economy Size and Capital Intensity/Abundance on PCM and Firm Size - Other mechanisms relating Trade and Financial Liberalization

Results More on the Mechanism Is the result related to changes in financial sector policies? Capital Deepening vs. Improved Allocation?

Results Why use FD instead of more direct ways of restricting competition? FD appears to be a more sophisticated method to be used when institutions allow only subtle interventions

Conclusion The change in relative strength of promoters resulting from Trade Liberalization is a good predictor of FD. The change in relative strength of promoters resulting from Trade Liberalization is a good predictor of FD. Allows us to solve –at least partially- causality issues and determine relevant policies. Allows us to solve –at least partially- causality issues and determine relevant policies. Policy perspective: Policy perspective:  Deep institutional factors play a role but…  Countries have the level of FD they choose  Policy convergence requires political conditions Trade liberalization does not automatically increase financial development. Look at distributive consequences. Trade liberalization does not automatically increase financial development. Look at distributive consequences.

Results Robustness Firm Size Measure Other Country characteristics assoc with PCM Event-Study Related Other Stories