Does Financial Openness Lead to Deeper Domestic Financial Markets? - PowerPoint PPT Presentation

Does Financial Openness Lead to Deeper Domestic Financial Markets? César Calderón (The World Bank) Megumi Kubota (University of York) FPD Academy Award Seminar The World Bank – July 28, 2010

Motivation  Salient features of the global economy:  Rapid integration of advanced countries and emerging market economies (EMs) to world capital markets.  Important changes in the patterns of saving and investment across the world.  Deepening of financial markets across industrial countries and EMs.

Motivation Rapid increase in financial openness (FO) and domestic financial development (DFD) over the last 25 years

Motivation  FO leads to faster DFD through different channels:  Eliminating financial repression and shifting interest rates to clearing-market competitive levels ( Baldwin and Forslid, 2000 )  Raising the degree of bank competition – i.e. adoption of more sophisticated banking techniques ( Levine, 1996; Caprio and Honohan, 1999 ).  Displacing inefficient financial intermediaries and creating pressures for a financial reform agenda ( Stulz, 1999; Stiglitz, 2000; Claessens et al. 2001; Chinn and Ito, 2006 ).

Motivation  FO, on the other hand, may lead to:  Risky behavior by banks and trigger boom-bust cycles ( Allen and Gale, 1999; Schneider and Tornell, 2004; Tornell and Westermann, 2005 )  Agency problems ( Allen and Gale 2000 ).  Buy risky assets during lending booms  Bubbles may burst into banking crisis and recessions  Financial liberalization may generate short-run tensions ( Kaminsky and Schmukler, 2008 )

Motivation  The effect of FO on DFD is theoretically ambiguous .  It becomes an empirical issue!  Prior: The effect of FO on DFD depends on some structural features of the economy.  Institutional framework  Legal infrastructure

Goal  Goal of the paper: Test whether rising FO has led to improvement in domestic financial markets.  Test whether the effects of FO on DFD may depend upon the country’s characteristics  the degree of institutional quality,  investor protection, and  trade openness

Contribution  Contribution to the literature:  First paper to evaluate the effects on DFD of FO using “ outcome ” measures of cross-border asset trade rather than indicators of the lack of restrictions to perform cross-border trade  Complements existing evidence that more intense financial linkages may lead to deeper domestic financial markets after controlling for the legal and institutional framework of the country

Main Findings  Rising FO enhances DFD  It enlarges size/activity of financial intermediaries Expansion of credit and higher assets   It improves the efficiency in the banking system Reduction of net interest margins   It contributes to the deepening of local stock markets and private bond markets Raising stock market capitalization and total value traded  Increasing private bond market capitalization   Structure of foreign assets and liabilities appears to play a role!  Accumulation of risky vs. riskless assets

Main Findings  Response of DFD to higher FO depends upon:  The level of institutional quality (IQ)  The degree of investor protection (IP)  International trade linkages of the domestic country (TO)  DFD enhanced by FO in countries with moderate to higher levels of IQ, IP, TO  Bank size/activity ( i.e. credit, deposits, assets)  Bank efficiency ( i.e. net interest margin)  Bond markets ( i.e. private bond market capitalization)

Main Findings  Rising FO deepens domestic financial markets.  (+) impact on bank credit, bank assets, net interest margins, capitalization of stock markets and private bond markets.  Structure of foreign assets and liabilities appears to play a role!  Accumulation of risky vs. riskless assets  Response of DFD to higher FO depends upon:  The level of institutional quality  The degree of investor protection  International trade linkages of the domestic country.

The Data  Sample of 145 countries (24 industrial economies)  Annual information, 1974-2007 (unbalanced panel)  Domestic financial development ( Beck, Demirguc- Kunt, Levine, 2009 )  Size and activity of financial intermediaries  Efficiency and structure of commercial banking  Stock market development  Bond market development

The Data  Financial openness  Outcome measures : Foreign assets and liabilities (Lane and Milesi-Ferretti, 2001, 2007)  Policy measure : Index of financial openness (Chinn-Ito, 2007)  Intensity of financial openness?  Control variables  PPP-adjusted real GDP  Inflation  Exchange rate regimes: dual and freely falling ( Reinhart and Rogoff, 2004; Ilzetzki, Reinhart and Rogoff, 2008 )

Methodology  Challenges of panel data estimation  Presence of unobserved period- and country-specific effects  Most explanatory variables are likely endogenous. Need to control for reverse causality .  Method: IV estimation  Need: Control reverse causation in financial openness  DFD may affect cross-border asset holdings.  Instruments for FO (Faria et al. 2007):  Institutional quality (summary index: rule of law, corruption, bureaucratic quality, and democratic accountability)  Legal origin of the country (La Porta et al. 1998)  Natural resource abundance, and area of the country  Initial size of the country

Baseline Regressions Financial Integration and Domestic Financial Development Baseline IV Regression Analysis Sample of 145 countries, 1974-2007 (annual observations) Dependent variable expressed as % of GDP, in logs Bank Bank Stock market Credit Assets Capitalization Explanatory variable [1] [2] [3] Financial Openness (FO) 0.094 ** 0.052 ** 0.349 ** Foreign liabilities (% GDP, logs) (0.03) (0.02) (0.08) Control variables Income per capita, lagged 0.641 ** 0.461 ** 1.048 ** (in logs) (0.05) (0.04) (0.13) Trade openness, lagged 0.288 ** 0.289 ** 0.208 * (0.04) (0.03) (0.11) (Exports and imports, % of GDP, logs) Inflation, lagged -0.232 ** -0.166 ** -0.223 ** (0.03) (0.03) (0.07) (in logs) Falling exchange rate -0.192 ** -0.138 ** -0.317 ** (lagged) (0.04) (0.03) (0.08) Dual exchange rate regimes -0.143 -0.043 -0.219 (lagged) (0.10) (0.08) (0.17) Observations 2441 2453 1380 R**2 0.857 0.883 0.851 Country- and time-effects Yes Yes Yes Numbers in parenthesis are robust standard errors. * (**) implies significance at the 10 (5) percent level.

Baseline Regressions Financial Integration and Domestic Financial Development Baseline IV Regression Analysis Sample of 145 countries, 1974-2007 (annual observations) Dependent variable expressed as % of GDP, in logs Bank Stock Market Credit Deposits Assets Capitalization Traded value Foreign assets 0.0758 ** -0.0035 0.0414 ** 0.4988 ** 1.0874 ** (% GDP, logs) (0.024) (0.019) (0.020) (0.080) (0.126) Nobs. 2360 2401 2374 1338 1367 R**2 0.859 0.881 0.886 0.855 0.859 Foreign liabilities 0.1021 ** -0.0437 ** 0.0394 * 0.3529 ** 0.4375 ** (% GDP, logs) (0.025) (0.019) (0.021) (0.075) (0.121) Nobs. 2360 2401 2374 1338 1367 R**2 0.860 0.881 0.886 0.856 0.858 Foreign assets and 0.1004 ** -0.0466 ** 0.0394 * 0.4546 ** 0.7490 ** liabilities (% GDP, logs) (0.027) (0.021) (0.022) (0.084) (0.136) Nobs. 2360 2401 2374 1338 1367 R**2 0.859 0.881 0.886 0.856 0.859 We control for income per capita, trade openness, inflation, and exchange rate regimes. All these control variables are lagged one period. Numbers in parenthesis are robust standard errors. * (**) implies significance at the 10 (5) percent level.

Baseline Results: A Scorecard All Industrial Developing Dependent Variable Countries Countries Countries Activity of financial intermediaries [+] [+] [ 0 ] Private credit by deposit money banks ( %of GDP, logs ) [+] [+] [ 0 ] Private credit by financial system ( % of GDP, logs ) [ - ] [ 0 ] [ 0 ] Bank deposits ( % of GDP, logs ) [ - ] [ 0 ] [ 0 ] Financial deposits ( % of GDP, logs ) Size of financial intermediaries [+] [+] [ 0 ] Total assets of deposit money banks ( % of GDP, logs ) [+] [ 0 ] [+] Total assets of the financial system ( % of GDP, logs ) [ 0 ] [ 0 ] [ 0 ] Liquid liabilities Efficiency of financial intermediaries [ 0 ] [ 0 ] [ 0 ] Overhead costs ( logs ) [ - ] [ - ] [ - ] Net interest margin ( logs ) [+] [ 0 ] [+] Bank concentration ( logs ) Stock markets [+] [+] [+] Stock market capitalization ( % of GDP, logs ) [+] [+] [ 0 ] Stock market total value traded ( % of GDP, logs ) [ 0 ] [ - ] [+] Number of listed companies ( logs) Bond markets [ - ] [+] [ - ] Private bond market capitalization ( % of GDP, logs ) [ - ] [+] [ 0 ] Public bond market capitalization ( % of GDP, logs ) Note: IV coefficient estimate of foreign liabilities (as % of GDP). [+] denotes a positive and statistically significant relationship, [ - ] denotes a negative and statistically significant coefficient, and [ 0 ] indicates a lack of significant in their relationship.

Robustness analysis  Our “ baseline ” estimates are robust to dropping from our sample:  Sharp variations in financial variables  High inflation episodes  Does the structure of external assets and liabilities matter?  Rising equity-related liability holdings leads to expansion of credit and deposits  Rising debt liability holdings is associated with contractions in credit and deposits.