THE EFFECT OF CAPITAL MARKET LIBERALIZATION IN EASTERN EUROPE: ECONOMIC GROWTH OR FINANCIAL CRISIS

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THE EFFECT OF CAPITAL MARKET LIBERALIZATION IN
EASTERN EUROPE ECONOMIC GROWTH OR FINANCIAL
CRISIS
Academy For Economic Studies, Bucharest -
Doctoral School of Finance and Banking (DOFIN)
- Dissertation Paper -

• MSc Student LAVINIA CRISTESCU
• Coordinator PhD. Professor MOISA ALTAR

Bucharest, July 2008
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CONTENTS

• Introduction
• Literature Review
• Model Specifications
• Empirical Analysis
• The Data
• Testing The Financial Liberalization Effect
• Conclusions
• References

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I. INTRODUCTION
Openes international financing path
Decreases the cost of capital
Positive effects
Increases investment
FINANCIAL LIBERALIZATION OF EQUITY MARKETS
Leads to a more rapid economic growth
Also, may lead to
A decline in credits portfolio quality
Negative effects
An increase in financial fragility
Macroeconomic volatility to external shocks
FINANCIAL CRISES AND LOSSES
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II. LITERATURE REVIEW

• Bekaert, Harvey and Lundblad (2005) Capital
  market liberalization leads to 1 increase in the
  economic growth rate.
• Kaminski and Reinhart (1998), Glick and
  Hutchinson (2001) Banking and currency crisis
  propensity increases in the aftermath of
  financial liberalization.
• Dell Aricia and Marquez (2004) Financial
  liberalization helps developing the credit sector
  by reducing the banks incentive to monitor
  potential debtors.
• Martin and Rey (2005) In normal circumstances,
  liberalization has the positive role to generate
  capital inflows, to create diversification
  opportunities and to stimulate economic growth
  in certain circumstances, liberalization can lead
  to financial crashes and a decrease in economic
  growth.
• Ranciere, Tornell and Westermann (2006)
  Financial liberalization has an positive
  influence on economic growth, although it
  increases the probability of financial crises.
• Henry (2000) Liberalization leads to an
  investment boom associated with a decrease in the
  cost of capital.

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III. MODEL SPECIFICATIONS

• GROWTH MODEL (Panel, linear)
• yi,t aXi,t ßFLi,t
  ?Ii,t ei,t
• Where
• yi,t is the real GDP per capita growth (in
  logarithm)
• Xi,t is a set of standard control variables
• FLi,t is a dummy for financial liberalization,
  taking the value 1 if the country i is
  liberalized in year t and zero otherwise
• Ii,t is a dummy for crisis, taking the
  value 1 if there is a banking or currency crisis
  in the year t and zero otherwise
• ei,t is a random, gaussian component.

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III. MODEL SPECIFICATIONS

• CRISIS MODEL (Panel, probit)

Wi,t aZi,t bFLi,t ?i,t

• Wi,t is a latent, unobserved variable (the
  crisis probability) who depends on
• - Zi,t a set of control variables
• - FLi,t dummy financial liberalization
• - ?i,t random, gaussian variable

F cumulative distribution function of a
standard normal
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III. MODEL SPECIFICATIONS
GROWTH MODEL CRISIS MODEL
Two step estimation procedure (Maddala (1983))
TREATMENT EFFECT MODEL (Heckman (1978))
It measures the average causal effect of a binary
variable (the treatment) on an output variable.
CRISIS DUMMY The treatment GROWTH REGRESSION
Output Equation CRISIS REGRESSION
Treatment Equation (represents the
probabiliy of receiving the treatment)
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III. MODEL SPECIFICATIONS

• TWO STEP ESTIMATION PROCEDURE
• 1. OBTAINING THE PROBIT ESTIMATES (ae, be)
• 2. COMPUTING AND ADDING TO THE GROWTH REGRESSION
  OF A HAZARD (hi,t) VARIABLE

F cumulative distribution function of a
standard normal ? probability density of a
standard normal ASSUMPTION the errors are
bivariate normal, but not independent
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III. MODEL SPECIFICATIONS

• TOTAL AVERAGE CAUSAL EFFECT OF FINANCIAL
  LIBERALIZATION
• Due to a change in the financial liberalization
  dummy from 0 to 1

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IV. EMPIRICAL ANALYSISa. The Data

• THE DATASET 13 EASTERN EUROPE COUNTRIES
• TIME PERIOD 1995 2007 (annual series)
• DATASOURCE AMECO DATABASE, CENTRAL BANKS
  STATISTICAL SERIES and BEKAERT and HARVEYS
  DATABASE FROM DUKE UNIVERSITY

NO. COUNTRY FINANCIAL LIBERALIZATION YEAR BANKING CRISIS YEAR CURRENCY CRISIS YEAR FINANCIAL CRISIS EU MEMBER FROM
1 BULGARIA,c 1998 1995, 1996 1995 1995, 1997 2007
2 CYPRUS 2004       2004
3 CZECH REPUBLIK,c 1994 1997 1997 1997 2004
4 ESTONIA,c 1996       2004
5 HUNGARY,c 1996 1995   1995 2004
6 LATVIA,c 1996 1995   1995 2004
7 LITHUANIA,c 1996 1995, 1996   1995, 1996 2004
8 MALTA 2004 1997   1997 2004
9 POLAND,c 1995       2004
10 ROMANIA,c 1997 2000   2000 2007
11 SLOVAKIA, c 1996   1998 1998 2004
12 SLOVENIA, c 1994       2004
13 TURKEY 1989 2000   2000 -
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IV. EMPIRICAL ANALYSISa. The Data

• GROWTH DEPENDENT VARIABLE
• REAL GDP PER CAPITA GROWTH real_gdp_gr
  log-difference of real GDP per capita
  (stationary, ADF)
• GROWTH DETERMINANTS
• CONTROL VARIABLES
• INITIAL REAL GDP PER CAPITA real_gdp the
  ratio between real GDP (2000 current market
  prices GDP in national currency / GDP Deflator)
  and total population (stationary, ADF)
• GOVERMENT SIZE gov_size ratio of final
  government consumption to GDP (2000 current
  market prices in national currency) (stationary,
  ADF)
• POPULATION GROWTH pop_gr log-difference of
  total population (stationary, ADF)
• INFLATION inflatia (log 100 National CPI
  all items) (stationary, ADF)
• FINANCIAL LIBERALIZATION DUMMY dummy_fl
  measurement official change in regulatory that
  allows foreigners to invest in domestic
  securities
• FINANCIAL CRISIS DUMMY dummy crisis takes
  value 1 in the year where banking or currency
  crisis occurs

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IV. EMPIRICAL ANALYSISa. The Data

• PROBIT DEPENDENT VARIABLE
• Ii,t through the unobserved, latent variable
  Wi,t
• PROBIT DETERMINANTS
• CONTROL VARIABLES
• GOVERMENT SIZE
• POPULATION GROWTH
• INFLATION (1 LAG)
• M2 / (INTERNATIONAL RESERVES GOLD) m2_res
  the ratio between the monetary aggregate M2 and
  international liquid reserves (not stationary,
  ADF gt first difference)
• OPENESS TO TRADE openess_trade the ratio
  between (total exports and imports) to GDP (not
  stationary, ADF gt first difference)
• REAL EFFECTIVE EXCHANGE RATE DETRENDED
  rero_hptrend01 real effective exchange rates
  (performance relative to 35 industrialized
  countries, EU) detrended using Hodrick Prescott
  filter, ?100 (stationary, ADF)
• DUMMY FINANCIAL LIBERALIZATION

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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
TREATMENT EFFECT MODEL TWO STEPS ESTIMATION
(STATA 9.1.)
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• THE ESTIMATORS CONFIDENCE LEVEL

All the regressions coefficients are significant
for a 95 level of confidence
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• TESTING THE PROBIT RESIDUALS
• Distribution

The probit residual is not normally distributed
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• Correlograms

There is no evidence of serial residual
correlation
There is no serial correlation of residuals
squared
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• TESTING THE GROWTH REGRESSION RESIDUALS

Histogram
Correlogram
The growth residuals are not normally distributed.
The growth residuals are not autocorrelated
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• TESTING THE GROWTH AND PROBIT RESIDUALS
  DEPENDENCE

New linear regression
ei,t Ci,t ?i,t ei,t

There is a dependence between the growth and the
probit residuals
gt The two residual series are not normally
bivariate and are not independent
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• TOTAL AVERAGE EFFECT OF FINANCIAL LIBERALIZATION

DIRECT EFFECT ße 0.2197727
INDIRECT EFFECT ?e EF(aeZi,t be) F(aeZi,t) 2.10817E-19
TOTAL EFFECT ße ?e EF(aeZi,t be) F(aeZi,t) 0.2197727
On average, the total effect of capital market
liberalization in Eastern Europe countries was a
positive one
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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• ESTIMATES DISCUSSION GROWTH REGRESSION

• REAL INITIAL GDP PER CAPITA (-0.289648, p lt
  1) economic growth rate is smaller for
  countries with a higher initial development
  level, consistent with Kormendi and Meguire
  (1985), Barro (1991, 1997), Sachs and Warner
  (1995).
• GOVERMENT SIZE (3.9021292, p lt 0.1) has a
  positive influence on growth, differs from Barro
  (1991, 1997), Sachs and Warner (1995) and is
  consistent with Caesseli (1996).
• POPULATION GROWTH (7.0823379, p lt 1) has a
  positive influence on growth, is consistent with
  Barro and Lee (1994) and differs from Kormendi
  and Meguire (1985), Mankiw (1992), Kelley and
  Schmidt (1995), Bloom and Sachs (1998).
• INFLATION (-0.17143785, p lt 0.1) leads to a
  decrease in economic growth rate, consistent with
  Barro (1997), Bruno and Easterly (1998), Motley
  (1998).
• DUMMY FINANCIAL LIBERALIZATION (0.2197727, p lt
  0.1) leads to an increase in economic growth
  rate, consistent with literature.
• DUMMY CRISIS (0.3893808, p lt 1) consistent
  with literature (Ranciere, Tornell, Westermann
  (2006)), has a negative influence on growth.

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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• ESTIMATES DISCUSSION PROBIT REGRESSION

• GOVERNMENT SIZE - (27.05248, p lt 5) increases
  the crisis probability
• POPULATION GROWTH (127.7304, p lt 5)
  increases the crisis probability
• M2 / (INTERNATIONAL RESERVES GOLD)
  (-0.000115, p lt 1) reduces the crisis
  probability and differs from the economic
  hypothesis.
• INFLATION (1 LAG) (1.216772, p lt 5)
  increases the crisis probability
• REAL EFFECTIVE EXCHANGE RATE HP DETRENDED
  (-0.140846, p lt 1) reduces the probability of
  crisis.
• From economical hypothesis (Kazaks (2000), Shatz
  and Tarr (2000) and Ranciere, Tornell and
  Westermann (2006), I first included in the probit
  non-linear regression Real Effective Exchange
  Rate Overvaluation (also 1 lag), defined as the
  percentage difference between Real Effective
  Exchange Rate and HP Detrended REER (IMFs
  definition). However, it showed no statistical
  significant influence within the model. Instead,
  HP detrended REER has a negative statistical
  significant effect.

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IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization

• ESTIMATES DISCUSSION PROBIT REGRESSION

• FINANCIAL LIBERALIZATION DUMMY (-1.60857, p lt
  5)
• decreases the probability of occurring a
  financial crisis!
• the result differs from the ones obtained in the
  literature and from the economic hypothesis
  considerred.

FINANCIAL LIBERALIZATION HAD AN AVERAGE POSITIVE
EFFECT ON GROWTH, COMPOSED BY
A POSITIVE DIRECT EFFECT
A POSITIVE INDIRECT EFFECT by decreasing the
crisis probability
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V. CONCLUSIONS

• Conclusions
• Capital market liberalization had an average
  positive effect on economic growth in Eastern
  Europe
• The other estimators influence is related to the
  economies specifications (emerging, most of them
  post-communist)
• The conclusions can only be applied to the
  analyzed sample, a generalization is not accurate
• Utility
• The joint analysis of financial liberalization
  improves economic decision making
• Further research
• Methodology improvement
• Analysis of crises appeared in developed
  economies
• Other determinants selection

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VI. REFERENCES

1. Eichengreen, B. and C. Arteta (2000), Banking
   Crises in Emerging Markets Presumptions and
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2. Davis, E. P. and D. Karim (2007), Comparing
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3. Bekaert, G. and C.R. Harvey (2003), Does
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4. Glick, R., X. Guo and M. Hutchinson (2004),
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5. Ranciere, R., A. Tornell and F. Westermann
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VI. REFERENCES

1. Kaminski, G. and C. M Reinhart (1999), The Twin
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