Financial Liberalization and the Real Economy

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Financial Liberalization and the Real Economy
Emerging Markets Finance May 6, 2005

• Geert Bekaert
• Columbia University and NBER
• Campbell R. Harvey
• Duke University and NBER
• Christian T. Lundblad
• Indiana University

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Real Effects of Equity Market Liberalization Plan

• Financial Effects
• Economic Growth
• Channels of Economic Growth
• Economic Volatility

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Real Effects of Equity Market Liberalization
Financial Liberalization/Openness

• In late 1990s, Bekaert and Harvey begin a
  research programme on financial openness
• Time-lines constructed for
• Official equity market liberalizations
• ADR and Country Fund Launches
• Capital account openness
• Banking reforms
• Privatizations
• Capital Flows
• FDI activity (to do)

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Real Effects of Equity Market Liberalization
Financial Liberalization/Openness

• Chronologies also contain
• Important political events
• Macroeconomic events
• Information on institutions
• Currently, 56 emerging markets and over 400 pages
  of information
• http//www.duke.edu/charvey/chronology.htm

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Real Effects of Equity Market Liberalization
Bekaert-Harvey Chronology
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Real Effects of Equity Market Liberalization 2.
Bekaert-Harvey Chronology
Country Fund
Capital account
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Bekaert-Harvey Chronology
Insider Trading Law
Insider Prosecution
Official Liberalization
First ADR announce
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Real Effects of Equity Market Liberalization
What is an Equity Market Liberalization?

• Liberalization dates
• Also consider alternative dates
• (1) First Sign
• - These dates based on the earliest date of
  official liberalization, first ADR and first
  closed-end fund
• - Example Taiwan
• - Official January 1991
• - First Sign May 1986
• (2) Intensity
• Investable Market Cap
• Total Market Cap

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Real Effects of Equity Market Liberalization
Theory suggests about financial liberalization

• Decreased cost of capital
• Changes might make country more sensitive to
  world shocks
• Impact on equity volatility not clear
• gt Empirical work consistent with predictions
• (Bekaert and Harvey (2000), Henry (2000),
  Kim and Singal (2000))

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Real Effects of Equity Market Liberalization
What we teach our students

• If cost of capital decreases, more projects NPVgt0
• Investment increases

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Real Effects of Equity Market Liberalization A
complex process
Financial Liberalization
Relaxing Fin Constraints
Growth Opportunities
Cost of Capital
Financial Development
Investment
Efficiency of Investment
Growth
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Real Effects of Equity Market Liberalization
Sharply different views from literature

• 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)

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Real Effects of Equity Market Liberalization
Panel econometric framework
where yi,tk,k real per capita GDP growth
between t and tk Qi,1980 initial GDP,
Xi,t control variables Libi,t
Liberalization variable k 5 years
BHL, JDE 2001
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Real Effects of Equity Market Liberalization
Classic regression on 95 countries
Predicting 5-year GDP growth
Approximately 1 per year over 5-year period
BHL, JFE 2005
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Real Effects of Equity Market Liberalization
Results robust to

• Definition of liberalization.
• Inclusion of fixed effects.
• Inclusion of time effects.
• Alternative growth horizons.
• Alternative assumptions on weighting matrix.
• Different year for initial GDP.
• Regional influences.
• Monte Carlo for standard errors/Bunching Bias.

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Real Effects of Equity Market Liberalization
and different from capital account liberalization
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Real Effects of Equity Market Liberalization
Issues

• Three remaining problems
• 1. Endogeneity
• 2. Simultaneity
• 3. Heterogeneity

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Real Effects of Equity Market Liberalization
Endogeneity

• Liberalization is not a random event
• Liberalizations might be timed when policy
  makers think prospects are good.
• Severe problem and no simple solution

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Real Effects of Equity Market Liberalization
Endogeneity

• To effectively deal with endogeneity, we need to
  come up with instruments that predict
  liberalization but not growth.
• A difficult task.
• Our approach is to attempt to control for growth
  opportunities.
• However, local GO measures may anticipate the
  liberalization
• effects.

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Global Growth Opportunities and Market
Integration
 

• Geert Bekaert
• Columbia University and NBER
• Campbell R. Harvey
• Duke University and NBER
• Christian T. Lundblad
• Indiana University
• Stephan Siegel
• Columbia University

BHLS NBER 10990
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Real Effects of Equity Market Liberalization
Growth opportunities
An exogenous measure of GO

• A countrys growth opportunities depend on its
  current industrial mix
• We weigh global P/E ratios by each countrys
  industrial mix to come up with a measure of a
  countrys growth opportunities
• Note we do not use local P/E ratios.

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Real Effects of Equity Market Liberalization
Growth opportunities
Predicting growth
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Real Effects of Equity Market Liberalization
Growth opportunities
Predict growth but do not drive out the
liberalization effect.
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Real Effects of Equity Market Liberalization
Simultaneous Reforms

• a) Trade sector
• Inflation policy
• Black market indicator
• Fiscal deficit
• Banking crises
• Financial development
• Legal reforms

only account for small fraction of growth effect
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Real Effects of Equity Market Liberalization
Heterogeneity of growth effect

• Why does growth react differently across
  different countries?
• Financial development
• Risks present in country
• Quality of institutions

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Real Effects of Equity Market Liberalization
Heterogeneity of growth effect
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Real Effects of Equity Market Liberalization
Heterogeneity of growth effect
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Real Effects of Equity Market Liberalization The
channels of economic growth
Where does increased economic growth come
from? Start with national income accounting
identity YC I G (X-M)
Neoclassical Channel
Crisis Literature
I
C
X - M
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Real Effects of Equity Market Liberalization The
channels of economic growth
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Real Effects of Equity Market Liberalization The
channels of economic growth
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Real Effects of Equity Market Liberalization The
channels of economic growth
Are the results puzzling (Henry
(2003))? Consider the Solow (1956) model
DYDA aDK (1-a)DL where DY change
in output per worker DA change in total factor
productivity DK change in capital stock DL
change in labor stock a elasticity
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Real Effects of Equity Market Liberalization The
channels of economic growth

After liberalization, the capital stock
increases by about 1 which is consistent with
the investment response to a decrease in the cost
of capital. But output increases by 1. Given
that a is approximately .33, there is a gap of
approximately 0.67.
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Real Effects of Equity Market Liberalization The
channels of economic growth

• The gap must be a result of increased total
  factor productivity, DA.
• We find that total factor productivity increases
• and this is not just a banking development effect
  

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Real Effects of Equity Market Liberalization The
channels of economic growth
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Real Effects of Equity Market Liberalization
Financial development, institutions, capital
allocation and growth

• Rajan and Zingales (1998) Financial development
  relaxes financing constraints
• Fisman and Love (2004) Financial development
  helps align GO with growth
• LLSV (legal) institutions investor protection
  are critical growth channel
• gt We interact GGOit with increases of financial
  development quality of institutions

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Real Effects of Equity Market Liberalization
Financial development, institutions, capital
allocation and growth
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Real Effects of Equity Market Liberalization
Financial development, institutions, capital
allocation and growth
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization

• There appears to be a positive mean growth effect
  to financial liberalization.
• Is there a cost?
• Does real volatility increase?
• BHL NBER 10560

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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization

• Two literatures
• Liberalization and Development
• Stiglitz (2000), Hausmann and Fernandez-Arias
  (1999), speculative foreign capital increases
  volatility in the real economy
• International Risk Sharing
• Van Wincoop (1999), Lewis (1999), no
  consensus about the extent of the welfare
  benefits due to decreased consumption growth
  volatility following market integration

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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
Panel Econometric Framework
where Stdevi,tk,k the standard deviation
of real per capita
consumption growth between t1 and tk, Xi,t
control variables, Libi,t
Liberalization variable k 5
years
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization

• We show the result is robust to
• Consumption as well as GDP volatility.
• Idiosyncratic and total volatility.
• Definition of liberalization/openness.
• Alternative dating of liberalizations.
• Controlling for world business cycle.
• Controlling for government size/social security.
• Regional Dummies/SUR estimation
• Monte Carlo for standard errors/Bunching Bias

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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization

• Additional Questions
• Endogeneity
• Simultaneous reforms
• Heterogeneity
• Is there a difference between a countrys ability
  to absorb shocks before and after equity market
  liberalization?

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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
Example Political/Institutional reforms
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization

• Why does consumption growth volatility react
  differently across different countries?
• Financial development
• Insurance through government
• Risks present in country
• Quality of institutions

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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization

• Financial development

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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
4. Quality of institutions
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
Relative shocks?

consumption growth volatility Dependent variable
GDP
growth volatility
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
Better measure to capture risk sharing benefits
idiosyncratic consumption growth volatility
where gi,tk k-period average of
consumption growth for country i, zi,t
control variables, Libi,t Liberalization
variable
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Real Effects of Equity Market Liberalization
Growth volatility and financial liberalization
1. Standard controls
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Real Effects of Equity Market Liberalization
Conclusions

• Financial liberalization spurs growth by 1 per
  annum over the five years
• No evidence of consumption binge
• Evidence of both investment and productivity
  gains
• Equity market liberalization does not increase
  economic volatility or idiosyncratic volatility
• Survives a battery of robustness experiments

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Real Effects of Equity Market Liberalization
Future and on-going research

• Financial development/Institutions
• Growth opportunities
• Liquidity and asset pricing
• The sequencing of liberalizations
• Case studies