RDP 2002-03: International Financial Liberalisation and Economic Growth 4. The Link between Capital Account Liberalisation and Economic Growth: A Brief Review of the Empirical Literature

Instead of providing a comprehensive review of the empirical literature, in this section we address some measurement issues and present the main findings of some recent studies.

4.1 Measuring Financial Integration

Measuring the extent of a country's international financial integration is not straightforward. The most commonly used measure is derived from information in the International Monetary Fund's Annual Report on Exchange Arrangements and Exchange Restrictions. It is a dummy variable that takes a value of 1 if a country has capital account restrictions in a given year and 0 otherwise. This measure has the advantage of wide coverage, as it is available for all IMF member countries on an annual basis starting from 1966. However, it is an imperfect proxy for financial openness as it does not distinguish between different types of capital controls. Moreover, this binary variable indicating the presence (or absence) of capital controls does not capture the intensity of capital controls.

The measure of financial openness developed by Quinn (1997) addresses some of these shortcomings. In addition to using restrictions on both residents and non-residents, this measure also distinguishes between different types of restrictions. By assigning numerical scores to various types of restrictions on governing capital account transactions, Quinn is able to provide some information about the intensity of capital controls for each country. While this measure is an improvement over the previous one, it is limited to 65 countries (21 developed and 44 emerging economies) for three years (1959, 1973 and 1988).

Both these measures based on capital account restrictions assume that the restrictions are fully effective, and therefore represent the countries' true degree of financial openness. However, studies have found that capital controls, especially in developing countries, have been of limited effectiveness. In particular, there is some evidence to suggest that restrictions on capital account transactions become less binding over time as investors find ways of circumventing them (see, for example, Dooley (1996)). To the extent that this is plausible, these measures would underestimate the degree of a country's financial openness.

Using capital flow data is one way of getting around this problem. One could interpret capital flow figures as measuring countries' effective financial openness. This is analogous to using trade volumes as a measure of trade openness. Another advantage of using capital flow figures is that they enable us to distinguish between different types of capital flows such as foreign direct investment, portfolio flows, bank loans etc. This level of disaggregation in turn allows us to more closely identify the different channels through which capital flows might affect economic growth. While there have been some improvements recently, capital flows data for some developing countries are incomplete and of poor quality. Given that all three measures come with caveats, it is important that we view them as complements to one another rather than substitutes.

4.2 Recent Empirical Work and Key Findings

A common approach to estimating the link between capital mobility and growth involves simple growth accounting regressions in the spirit of Mankiw, Romer and Weil (1992). Most studies include a set of control variables, and one or more of the financial openness variables described above. The data are typically averaged over five, ten or twenty years so that the data set is converted into either a cross-sectional data set or a panel data set.

Following the theoretical literature discussed at the end of Section 3, a number of recent studies also attempt to capture the extent to which distortions in the domestic economy influence the way financial liberalisation affects growth. As these distortions – information asymmetry and moral hazard – are difficult to quantify, these studies typically use different measures of institutional development and policy environment, with the idea being that these distortions are less in countries with strong institutions and sound policy environment. Commonly used variables include different measures of financial market development and the quality of other domestic institutions such as legal institutions, accounting standards etc. The inflation rate and the fiscal account are typically used to proxy the domestic policy environment.

In a widely cited study, Rodrik (1998) concludes that capital account convertibility is essentially uncorrelated with long-run economic performance. Using data for a sample of 100 developed and developing countries, and controlling for other determinants of growth, Rodrik regresses growth in per capita GDP on capital account openness. Openness for each country is defined as the number of years during the sample period when the country's capital account was free from any restrictions (as measured by the binary indicator). Rodrik finds no association between capital account liberalisation and growth. He also tests the hypothesis that capital account convertibility might have had beneficial effects in countries with strong institutions. Rodrik finds no evidence for this in the data – interacting capital account liberalisation with indices of the quality of public institutions yields insignificant and often wrongly signed coefficients.

These results are broadly consistent with those of Kraay (1998), who undertakes a more comprehensive examination of the effect of capital account liberalisation on investment, growth and inflation. The study includes data from 117 countries over the period 1985–1997, and uses all three measures of financial openness described in Section 4.1, and different measures of financial market development and policy environment.^[8] The link between capital account liberalisation and growth is found to be weak, and only those regressions that use capital flow data yield positive and statistically significant results. The evidence for the hypothesis that capital account liberalisation is successful in countries with a strong financial sector and a good policy environment is also found to be weak.

The results from Klien and Olivei (1999) are somewhat kinder to the hypothesis that financial liberalisation is good for growth. They find that countries that had relatively open capital markets during 1976–1995 (defined as the number of years when the capital account was free of any restrictions) experienced relatively higher rates of economic growth. This result however is largely driven by the developed countries in the sample. Using the Quinn (1997) measure of financial openness, Edwards (2001) comes to a similar conclusion. While liberalisation is found to boost economic growth, the effect is limited to the relatively developed countries in the sample. The interaction term between liberalisation and per capita GDP enters positively, indicating that the effect of a more open capital account increases with the country's initial level of development. Furthermore, the coefficient on the openness index is negative, suggesting that an open capital account may in fact have a negative effect at low levels of development.

The studies reviewed here suggest that the link between financial liberalisation and growth is weak at best. While these studies vary considerably in their country coverage, sample period, and estimation techniques, with the exception of Kraay (1998), they all use information on capital account restrictions to measure financial liberalisation. These studies therefore tell us about the implications of policy and changes in policy toward the capital account, not of the implications of capital flows themselves. For reasons already discussed, these measures of financial openness may not necessarily reflect the true extent of a country's financial integration. These measures also do not tell us whether different types of capital flows affect growth differently. While some work has been done on the effects of foreign direct investment on growth, very little is known about the effects of bank and portfolio flows that have become increasingly important sources of external financing for many developing countries. In the next section, we examine the implications of the composition of capital flows for economic growth.

Footnote

Kraay (1998) uses four different measures of financial sector strength: M2/GDP, domestic credit to the private sector as share of GDP, number of banking crises per year, and an index of the restrictiveness of bank regulations. To capture the broader policy environment, Kraay constructs an index as the weighted average of fiscal deficits and inflation following Burnside and Dollar (1997). The indices of the extent of corruption and quality of bureaucracy developed by the International Country Risk Guide (ICRG) are used to measure institutional development. The black market premium is used to measure the extent of domestic distortion. [8]