Does Financial Liberalization Spur Growth? Emerging Markets Corporate Finance February 2003 Does Financial Liberalization Spur Growth? Geert Bekaert Columbia University and NBER Campbell R. Harvey Duke University and NBER Christian T. Lundblad Indiana University

Real GDP Growth Five Years Before and After Financial Liberalizations

Financial Liberalization Financial Development Growth Cost of Capital Opportunities Relaxing Fin Constraints Financial Development Investment Efficiency of Investment Growth

Financial Liberalization and Growth Controversial exercise 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 Liberalization and Growth What we already know (too many references to list!): Financial/banking development associated with higher growth Cost of capital decreases Investment increases

Financial Liberalization and Growth Outline: 1. Did liberalization spur growth? Large panel of data Cross-sectional growth regression with temporal dimension 2. How did liberalization spur growth? 3. Accounting for the liberalization effect Is is macro-economic reforms? Is it financial development? Other simultaneity biases? 4. Conclusions

Financial Liberalization and Growth Caveats: Not much guidance from theory. As a result, it is important to conduct extensive robustness experiments

Financial Liberalization and Growth Econometric Framework: where yi,t+k,k is real per capita GDP growth between t and t+k Qi,1980 is initial GDP, Xi,t represents control variables Libi,t is a Liberalization indicator variable

Financial Liberalization and Growth Econometric Framework:

Financial Liberalization and Growth Econometric Framework: ST is the variance covariance matrix of the sample orthogonality conditions

Financial Liberalization and Growth Key issues: Temporal dimension Different weighting matrices Liberalization variable Choice of “k” Endogeneity of the liberalization decision

Financial Liberalization and Growth Liberalization dates: Use Bekaert and Harvey (JF 2000) “official liberalization” dates These dates are based on a detailed chronology of important regulatory events Augmented with IFC frontier markets and three developed markets, Spain, New Zealand and Japan

Financial Liberalization and Growth Data: Four samples determined by availability of data Sample I: 95 countries Sample II: 75 countries [macroeconomic and demographic data]

Financial Liberalization and Growth Data: Four samples determined by availability of data Sample III: 50 countries Sample IV: 28 countries [add financial development indicators] As data requirements become more stringent, the variance of GDP levels across countries in the sample decreases.

Financial Liberalization and Growth Liberalization dates: Use Bekaert and Harvey (JF 2000) “official liberalization” dates These dates are based on a detailed chronology of important regulatory events Augmented with IFC frontier markets and three developed markets, Spain, New Zealand and Japan

Financial Liberalization and Growth Liberalization dates: Robustness of our results checked by examining Bekaert and Harvey (2000)’s “First Sign” dates These dates based on the earliest date of {official liberalization, first ADR and first closed-end fund} Example: Thailand “Official” 1987:09 “First Sign” 1985:07

Financial Liberalization and Growth Liberalization dates: Capturing “intensity” or “comprehensiveness” of the liberalization Ratio of IFC investable market cap to global stocks (Bekaert (1995) and Edison and Warnock (2002)) U.S. holdings of domestic market capitalization Is it just a proxy for capital account openness? [See Rodrik-Edwards debate]

Financial Liberalization and Growth Are the dates exogenous? Counter examples Spain in the EU Some countries cannot liberalize their financial markets

Financial Liberalization and Growth Findings so far: We document a liberalization effect on growth with certain "standard control variables"

Financial Liberalization and Growth Findings so far: The liberalization effect is robust to different definitions of liberalization dates to business cycle or interest rate controls allowing for intensity of liberalization ...and independent of capital account liberalization

Financial Liberalization and Growth Channels of increased growth: Both: increased investment, partially through a cost of capital effect and increased productivity (which is different from the financial development literature)

Financial Liberalization and Growth On the mechanism ... Liberalization does not lead to consumption binge investment increases trade balance decreases

Financial Liberalization and Growth On the mechanism ... Investment increases - but you need a minimum “country quality level” to see effect decreased cost of capital associated with more investment

Financial Liberalization and Growth On the mechanism ... Productivity increases and this is not just a banking development effect

Financial Liberalization and Growth Accounting for the liberalization effect: We investigate whether part of the effect can be ascribed to macroeconomic reforms financial development other regulatory reforms

Financial Liberalization and Growth Accounting for the liberalization effect: Macroeconomic reforms ... Liberalization not spuriously reflecting macroeconomic reforms we control for trade openness, inflation, black market premiums, and government deficits

Financial Liberalization and Growth Accounting for the liberalization effect: Financial development ... Degree of banking and equity market development is important but independent boost from liberalization we examine the size of private credit, equity market activity, and equity market size

Financial Liberalization and Growth Accounting for the liberalization effect: Other regulatory reforms ... The financial liberalization/growth effect is not a post-banking crisis effect The enforcement of law and institutions are important

Financial Liberalization and Growth Conclusions Financial liberalization spurs growth by 1% per annum over the five years Survives a battery of robustness experiments We understand better the channels whereby growth impacted by financial liberalization Liberalization effect not spuriously accounted for by a host of other events such as macro-economic reforms

Financial Liberalization and Growth Conclusions Financial liberalization has a very important economic effect

Financial Liberalization and Growth Conclusions Financial liberalization has a very important economic effect Consider economic impact of improvements plus a equity market liberalization Liberalization Total Growth = 3.02%

Financial Liberalization and Growth Future and on-going research Growth volatility Financial development Liquidity and asset pricing The sequencing of liberalizations