Dependencia Revisited:

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Dependencia Revisited
May 5th, 2009
Financial Liberalization and Inequality In Latin
America

• An Honors Thesis
• Benjamin Mandel
• Brown University
• Department of Economics
• Thesis Adviser Professor Ross Levine

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Purpose

• Assess trend of financial internationalization in
  Latin America from a new perspective
• Explore the extent to which increasing economic
  inequality is attributable to liberalization
• Compare findings with the dependencia school of
  thought
• Identify political economy implications for the
  region

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Motivation

• Dependencia (Dependency Theory)
• Attempted to explain persistent underdevelopment
  of Latin America
• Raúl Prebisch Thesis of Unequal Exchange
  (1950)
• Disproven in theory and practice
• Many of the regions economies have grown
  markedly more international in recent years
• Income inequality remains high throughout Latin
  America
• Still climbing in many cases

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Why does inequality matter?

• Inequality is not necessarily a bad thing!
• Beneficial at low levels of economic development
  (Galor Zeira, 1993)
• Poor can still gain in absolute terms (Ravallion,
  2005)
• Wealthy may face higher apparent inflation rates
  (Lopez Perry, 2008)

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Why does inequality matter?

• Reasons for concern
• Latin America is beyond early phases of
  development
• Urbanization
• Financial sophistication
• Poses obstacle to poverty-reducing capabilities
  of economic growth (Ravallion, 2005)
• Perpetuates underdevelopment by limiting growth,
  institutional quality, and education (Easterly,
  2005)

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Financial Liberalization

• Components (Hermes Lensink, 2005)
• Decreased barriers to entry for foreign financial
  institutions
• Deregulated capital markets
• Eased credit and interest rate controls
• Can be decomposed into liberalization of the
• Capital account (asset transactions)
• Current account (balance of trade)
• Equity or capital markets

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Financial Liberalization

• Beneficial if

Increased Competition
Greater Saving
Adoption of Improved Governance Practices
Decreased Cost of Capital
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Financial Liberalization

• Detrimental if

Increased Competition
Failure of small, relationship-based banks
Relaxed screening and monitoring due to reduced
margins

• Moreover, liberalization must occur within a
  sound regulatory atmosphere (Hermes Lensink,
  2005)

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Liberalization ? Growth

• Evidence of positive correlation between
  financial liberalization and economic growth
  globally (Bekaert, Harvey, Lundblad, 2004
  Hermes Lensink, 2005)
• Latin America has shared in the global growth
  experience (Easterly, Loayza, Montiel, 1996)
• Growth in 1990s exceeded rates in previous
  decades
• Refuted perception that Latin Americas results
  in terms of growth and social progress have not
  yet met expectations

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Liberalization ? Growth

• My contention
• If liberalization has promoted growth in Latin
  America at the expense of economic welfare, then
  it would be reasonable to question the wisdom of
  the recent economic policy shift.

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Links with Inequality

• Four conduits
• Growth (Arestis Caner, 2004)
• Can exacerbate inequality in the absence of solid
  redistributive framework
• Trade/capital market openness (Do Levchenko,
  2006)
• Foreign competition effect
• Political power effect
• Crisis (Arestis Caner, 2004)
• Liberalizations can increase vulnerability to
  crisis
• Of 20 crises in Latin America, 15 were followed
  by increases in Gini
• Foreign bank penetration (Clarke, Cull, Martínez
  Peria, and Sánchez, 2003)
• By year-end 2000, foreign financial institutions
  controlled 38 of all loans in Latin America, up
  from 15 in 1996
• SME lending
• Intensive vs. extensive axis

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Hypotheses

• Liberalization is associated with diminished
  income inequality in Latin America
• Solid redistributive framework, foreign
  competition effect dominates, credit improves on
  extensive axis
• Liberalization is associated with exacerbated
  income inequality in Latin America
• Poor redistributive framework, political power
  effect dominates, credit improves on intensive
  axis

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• Difficult to identify a strong link at first
  glance!

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Methodology

• Models regressions from Bekaert, Harvey, and
  Lundblad (2004)
• Emulates Beck, Demirgüç-Kunt, Levine (2007) in
  adapting methodology used in growth literature by
  applying it to growth in Gini rather than GDP
  growth
• Variable of interest is financial liberalization
  rather than financial development

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Methodology

• GrowthInGinii,t-1,t change in Gini in country i
  between periods t1 and t
• Xi,t vector of control variables measured in
  country i in period t
• Institutional quality, government consumption,
  secondary schooling, life expectancy, population
  growth, and terms-of-trade growth
• Libi,t one of four possible liberalization
  scores assigned to country i during period t
• Current Account Openness (Quinn Toyoda, 2008)
• Capital Account Openness (Quinn Toyoda, 2008)
• Official Equity Market Liberalization (Bekaert
  Harvey, 2002)
• Financial Openness (Loayza, Olaberria,
  Rigolini, 2009)
• ßo regression constant, ui,t regression error
  term

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Methodology

• Cross-sectional Data
• Pooled ordinary least squares (OLS)
• Establishes basic correlations of liberalization
  with inequality
• Panel Data
• Fixed Effects (OLS)
• Random Effects (GLS) more efficient
• Control for contemporaneous reform and crisis
• Dynamic Panel Data
• Generalized method of moments (GMM) estimation
  model
• Arellano Bond (1991) add lagged values of the
  dependent variable as instruments
• Strongest assumptions, immunizes from endogeneity

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Results

• Cross-sections show all liberalization measures
  to be positively correlated with Gini growth
• Financial Openness is only measure of
  liberalization to enter significantly at 5 level
  in any specifications
• Most interesting and statistically significant
  results came in specifications that included
  interaction term
• LiberalizationInstitutions
• Showed that liberalization can be linked with
  diminishing or worsening inequality, depending on
  the quality of institutions during reform
• In GMM test, going from worst to best
  institutions in sample would dissipate Gini
  growth by 73 of a standard deviation

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Implications

• Although financial repression is not desirable,
  its alternative is not traditional
  liberalization. When financial liberalization is
  applied without first maintaining macroeconomic
  stability and establishing the supporting
  institutions and policies, even when it brings
  economic expansion, it often comes at the cost of
  devastating crises and increasing economic
  inequality.
• (Arestis and Caner, 2004, 23)
• Nations must have their institutional house in
  order before embarking on a course of liberal
  economic reform

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Dependencia Revisited

• Dependencia seems to have been disproven once
  again
• Poor growth and living standards have likely been
  rooted in poor institutions, not in economic
  interactions with the industrialized world

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Conclusion

• Poor institutions interact with liberalization
  by
• Hindering redistribution of new income (Growth
  channel)
• Disproportionately favoring firms that have
  access to foreign markets ? political power
  effect dominates (Trade/Capital Account Openness
  channel)
• Increasing vulnerability to systemic financial
  crisis (Crisis channel)
• Improving credit more along intensive than
  extensive access, diminishing SME credit (Foreign
  Bank Penetration channel)

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Conclusion

• Latin Americas emergent New Left (Venezuela
  and Bolivia) is not necessarily correct to opt
  for economic isolationism
• It appears difficult to achieve economic health
  by aiming for equity without seeking the growth
  from participation in a global economy
• Brazil is shining example of social progress amid
  steady growth
• Topics for future study
• Relationships between specific components of
  international finance and inequality amid
  liberalization
• Further instrumentation of variables (e.g.
  growth)
• Ancillary effects of liberalization poverty,
  employment, remittances, etc.

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Acknowledgments

• Professor Ross Levine
• Martin Goetz
• Economists who lent data and insights
• My unparalleled friends and family

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Questions?