INTERNATIONAL FINANCIAL INTEGRATION AND ECONOMIC GROWTH - A PANEL ANALYSIS

By Xuan Vinh Vo

School of Economics and Finance

University of Western Sydney, Australia

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Abstract

This paper employs a new panel dataset and a wide assorted number of indicators both de jure and de facto measures to proxy for international financial integration to investigate the relationship between international financial integration and economic growth. Using 79 countries with the data covering the period from 1980 to 2003, our analysis indicates a weak relationship between international financial integration and economic growth. Our data also show that this relationship is not different even though we control for different economic conditions.

JEL Classification: F3, 04, 016

Keywords: international financial integration, economic growth, panel, FDI, Portfolio Investment, Private Capital Flows.

Acknowledgement

The author is grateful for advices and suggestions from Kevin Daly, Tom Valentine, and Craig Ellis. Financial support from University of Western Sydney is also acknowledged. Any remaining errors are of course my own responsibilities.

1.  Introduction

With the development of financial market and increased degree of international financial integration around the world, many countries especially developing countries are now trying to remove cross-border barrier and capital control, relaxing the policy on capital restrictions and deregulating domestic financial system. This paper will empirically examine the growth impacts of international financial integration.

This paper is going to contribute to the existing literature on the impacts of international financial integration on economic performance in a number of ways.

Firstly, we examine an extensive array of international financial integration indicators, both de jure and de facto of international financial integration. We examine the IMF’s official restriction dummy variable[1] as well as the newly developed capital restriction measures by Miniane (2004). Furthermore, we explore various measures of capital flows and in disaggregation including total assets and liabilities, total liabilities, FDI, portfolio, and total capital flows as share of GDP (a total of 18 de facto indicators). Moreover, we consider measures of just capital inflows as well as measures of gross capital flows (inflows plus outflows) to proxy for international financial integration because capital account openness is defined both in terms of receiving foreign capital and in terms of domestic residents having the ability to diversify their investments abroad. In addition, we examine a wide array of international financial integration proxies because each indicator has advantages and disadvantages[2].

Secondly, we develop and examine a large number of new measures of international financial integration, both in flows and stock measures, especially in disaggregation. As proxies for international financial integration, we first examine the flow measures of capital flows. In this regard, we use FDI inflows (as a share of GDP), FDI inflows and outflows (as a share of GDP), portfolio investment (equities and debts) inflows (as a share of GDP), gross portfolio investment inflows and outflows (as a share of GDP), gross private capital flows[3] (as a share of GDP). In addition, we use the stock measure of these indicators. Since we want to measure the average level of openness over an extended period of time, these stock measures are more useful additional indicators. Furthermore, these stock measures are less sensitive to short-run fluctuations in capital flows associated with factors that are unrelated to international financial integration, and may therefore provide more accurate indicators of international financial integration than capital flow measures. In particular, we examine both the accumulated stock of liabilities (as share of GDP) and the accumulated stock of liabilities and assets (as share of GDP). Furthermore, we break down the accumulated stocks of financial assets and liabilities into stock of FDI and stock of portfolio inflows and outflows in assessing the links between economic growth and a wide assortment of international financial integration indicators. There are some authors who previously use a subset of these indicators. For example, Lane and Milesi-Ferretti (2002) get credit as the first to compute the accumulated stock of foreign assets and liabilities for an extensive sample of countries. Edison et al. (2002) use this dataset for their study in measuring international financial integration. Thus, we advance other studies by carefully computing, developing and investigating these additional international financial integration indicators as well as a large number of countries in our dataset. As a result, we believe that our empirical investigation provides a far more complete picture of the relationship between international financial integration and economic growth compared to other previous studies using a small subset of these indicators and smaller number of countries.

Thirdly, since theory and some past empirical evidence suggest that international financial integration will only have positive growth effects under particular institutional and policy regimes (Edison et al. 2002), we examine an extensive array of interaction terms. Specifically, we examine whether international financial integration 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 international financial integration boosts growth.

Fourthly, 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 international financial integration-growth relationship. Since each of these econometric biases is a serious concern in assessing the growth-international financial integration nexus, applying panel techniques enhances the confidence we can have in 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.

As mentioned above, we empirically study the relationship between broad measures of international financial integration and growth with broad controlling macroeconomic and country risk conditions. Other researchers focus instead on a much narrower issue: restrictions on foreign participation in domestic equity markets. Levine and Zervos (1998) construct indicators of restrictions on equity transactions by foreigners. They show that liberalizing restrictions boosts equity market liquidity. Henry (2000a; 2000b) extends these data and shows that liberalizing restrictions on foreign equity flows boosts domestic stock prices and domestic investment. Bekaert et al. (2004) 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 specific country risk environments.

The remainder of the paper is organized as follows. Section two reviews the literature and theoretical framework. Section three develops the econometric model. Section four describes the methodology. Section five presents the data. Section six reports the empirical results and section seven concludes the paper.

2.  Literature Review

This section assesses the current literature about the impacts of international financial integration[4] on the economic performance both theoretically and empirically. Theoretically, evidences provided are mixed. According to some researchers who mention the pros of international financial integration, international financial integration facilitates risk-sharing, improves international diversification and thereby enhances production specialization, capital allocation, and economic growth (Obstfeld 1994; Acemoglu & Zilibotti 1997; Edison et al. 2002). Further, it is argued in the standard neoclassical growth model that international financial integration smooths the flow of capital from capital-abundant to capital-scarce countries with positive growth effects. In addition, international financial integration may boost the functioning of domestic financial systems through the intensification of competition and the importation of financial services. This may tend to reduce profits of local firms but spillover effects through linkages to supplier industries may reduce input costs, raise profits and stimulate domestic investment and this will result in positive growth effects (Markusen & Venables 1999; Klein & Olivei 2000; Levine 2001; Edison et al. 2002; Agenor 2003). Moreover, international financial integration can facilitate the transfer or diffusion of managerial and technological know-how, particularly in the form of new varieties of capital inputs (Grossman & Helpman 1991; Borenzstein et al. 1998; Berthelemy & Demurger 2000; Agenor 2003).

On the other hand, many other authors disbelieve the positive effects of international financial integration. Boyd and Smith (1992) state that international financial integration in countries with weak institutions and policies – for instance, weak financial and legal systems - may actually induce a capital out-flow from capital-scarce countries to capital-abundant countries with better institutions. Bhagwati (1998), in addition, argues that international financial integration in the presence of pre-existing distortions can actually retard growth. Rodrick (1998) and Edwards (2001) further blame that the increased degree of international financial integration was ultimately behind the succession of crises that the emerging markets experienced during the mid-1990s. According to this school of thoughts, international financial integration inflicts many costly disadvantages but offers very limited benefits to emerging nations. It has been argued that, since emerging markets lack modern financial institutions, they are particularly vulnerable to the volatility of global financial markets. This vulnerability will be exaggerated in countries with a more open capital account. Edison et al (2002) also do not support the view that international financial integration per se accelerates economic growth, even when controlling for particular economic, financial, institutional, and policy characteristics. 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 contemporaneous policy debate over the growth effects of international financial integration have produced an escalating empirical literature, resolving this issue is complicated by the difficulty in measuring international financial integration. 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).

Empirical evidence yields conflicting conclusions about the growth effects of international financial integration. Grilli and Milesi-Ferretti (1995), Kraay (1998) and Rodrik (1998) find no link between economic growth and the IMF capital restriction measure. Edison et al (2002) use the data of up to 57 countries over 20 years period and find out that international financial integration per se does not accelerate economic growth, even when controlling for particular economic, financial, institutional and risk characteristics.

In contrast, Edwards (2001) suggests that the positive relationship between capital account openness and productivity performance only manifests itself after the country in question has reach a certain degree of development. He thus argues that to take advantage of international financial integration, a country needs to develop to a level of sound financial institutions and advanced domestic financial market.

Edwards (2001) also finds that the IMF capital restriction measure is 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 international financial integration. Arteta et al. (2001) and Edison et al. (2002), however, argue that Edwards’s results are not robust to small changes in the econometric specification. While Quinn[5] (1997) finds that his measure of capital account openness is positively linked with growth, Kraay (1998) and Arteta et al. (2001) 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 et al. 1994) educated (Borenzstein et al. 1998), or financially developed (Alfaro et al. 2004), a research by Carkovic & Levine (2002) contends that these results are not robust to controlling for simultaneity bias.

In light of the current literature, this research is significant in terms of contribution in provision of a complete picture of the growth - international financial integration relationship to the existing literature. This paper is also of interest to the policy makers and researcher to uncover the impact of international financial integration on economic performance.

3.  The Model

To satisfy the conditions mentioned in the previous part, we formulate the model that is represented as follow:[6]

Y1 = α + βi*I +βf*IFI + βx*X + є (1)

And we interact the IFI with each of the variables in X:

Y1 = α + βi*I +βf*IFI + βx*IFI*X + βy*X + є (2)

If we have a positive βx then it would mean that IFI will have a greater effect on economic growth with greater X and vice versa, it will have lesser impact with greater X.[7]

Where:

-  Y1 is per capital GDP growth

-  I is a set of variables always included in the regression.

-  IFI is individual international financial integration variable of interest.

-  X: a subset of variables chosen from a pool of variables identified by past studies as potentially important explanatory variables of growth. These are controlling variables.

In this paper, I-variables include:

-  the investment share of GDP (INV)

-  the lagged value of real GDP per capita (LGDPCAP)

-  the lagged value of secondary-school enrolment rate (EDU)

-  the annual growth rate of population (POPU)

IFI variables include:

De jure indicators

-  IFI01: capital control variable developed by Miniane (2004)

-  IFI02: IMF dummy variable from AREAEA

It is clear that in this category, a smaller value of capital control variable or IMF dummy variable implies a greater degree of international financial integration.

De facto Measures

Flows Measures

-  IFI03: Gross FDI as share of GDP

-  IFI04: FDI inflows as share of GDP

-  IFI05: Gross Portfolio Investment as share of GDP

-  IFI06: Portfolio investment inflows as share of GDP

-  IFI07: Total FDI + Portfolio Investment Inflows + Outflows (as share of GDP) = IFI03+IFI05