Draft March 8, 2001
Economic Growth and Financial Liberalization
Geert Bekaert and Campbell R. Harvey
1. Introduction
From 1980 to 1997, Chile experienced average real GDP growth of 3.8% per year while
the Ivory Coast had negative real growth of -2.4% per year. Why? Attempts to explain
differences in economic growth across countries have taken center stage in the
macroeconomic literature again (see Barro and Sala-i-Martin (1995),1 Jones (2000)2).
Although there is no agreement on what the determinants are of economic growth, most
of the literature has found evidence of conditional convergence. Poorer countries grow
faster than richer countries, once it is taken into account that poor countries tend to have
lower long-run per capita GDP, for example, because of the poor quality of their capital
stock (both physical and human). Sachs and Warner (1995)3 have argued that policy
choices, such as respect for property rights and open international trade, are important
determinants of long-run growth.
Although the role of trade openness remains hotly debated (see Rodrik and Rodriguez
(1998)4), there are some interesting differences between the two countries we mentioned.
First, the Ivory Coast has a larger trade sector than Chile. Second, Chile liberalized its
capital markets, in particular its equity market, to foreign investment in 1992. After the
liberalization, it grew by 6.4% a year. The eighties and nineties witnessed a number of
financial liberalizations. Given the recent currency crises and their adverse economic
consequences, the role of financial liberalizations and foreign capital flows in the
economic welfare of developing countries are being put in question. What effect did they
have on growth? Our recent work with Christian Lundblad tries to answer this question.
2. Why would financial liberalization affect economic growth?
There are a number of channels through which financial liberalization may impact
growth. First, foreign investors, enjoying improved diversification benefits, will drive up
local equity prices permanently thereby reducing the cost of capital. Both Bekaert and
Harvey (2000a)5 and Henry (2000a)6 marshal evidence that the cost of capital goes down
after major regulatory reforms. Bekaert, Harvey and Lumsdaine (2000a)7 show that a
capital inflow leads to a permanent positive price effect. Moreover, Bekaert and Harvey
(2000a)8 and Henry (2000b)9 indicate that investment increases. If the additional
investment is efficient, economic growth should increase. However, in the aftermath of
the recent crises, some economists felt foreign capital had been wasted on frivolous
Bekaert is the Leon G. Cooperman Professor of Finance and Economics at Columbia University’s
Graduate School of Business, New York, NY and Research Associate in the NBER’s Program on Asset
Pricing. Harvey is J. Paul Sticht Professor of International Business at the Fuqua School of Business, Duke
University, Durham, NC and Research Associate in the NBER's Program on Asset Pricing. consumption and
wasteful investment, undermining the benefits of financial
liberalization.
Second, there is now a large literature on how improved financial markets and
intermediation can improve growth (for example, Bencivenga and Smith (1991)10) and
financial liberalization may promote financial development. Furthermore, foreign
investors may also demand better corporate governance to protect their investments
hereby reducing the wedge between the costs of external and internal financial capital,
and further increasing investment (see Rajan and Zingales (1999)11 and Love (2000)12 for
an analysis of the link between financial development and these “financing constraints”).
3. Measuring the liberalization effect on economic growth
Most of the growth literature uses purely cross-sectional techniques to measure growth.
The nature of our question forces us to introduce a temporal dimension into the
econometric framework. In Bekaert, Harvey and Lundblad (2000)13, we propose a time
series panel methodology that fully exploits all the available data to measure how much a
financial liberalization increases growth. We regress future growth (in logarithmic form),
averaged over periods ranging from 3 years to 5 years, on a number of pre-determined
determinants of long-run steady state per capital GDP, such as secondary school
enrollment, the size of the government sector, inflation and trade openness, and on initial
GDP (measured in logarithms) in 1980. The right-hand side variables also include a
liberalization indicator variable, based primarily on the analysis of regulatory reforms in
Bekaert and Harvey (2000a)14 and (2000b)15.
To maximize the time-series content in our regressions, we use overlapping data. For
example, both growth from 1981 to 1986 and growth from 1982 to 1987 are used in the
same regression. The resulting correlation in the model's residuals is corrected for in the
standard errors. The model is estimated by the General Method of Moments. The
technique allows adjustments for correlations of residuals across countries and different
variances of the residuals across countries and over time (heteroskedasticity).
The main statistic of interest is the t-statistic on the liberalization indicator variable.
Since we have so few time-series data, we also conduct a Monte Carlo analysis to
examine how well this statistic behaves in sample sizes similar to the ones available for
our analysis, under the null of a zero liberalization effect. We do find that we have to
raise the normal cut-off values of the t-statistics somewhat before we can conclude there
truly is a statistically significant rejection of the null hypothesis of no liberalization
effect.
4. The liberalization effect: magnitude and robustness
In Bekaert, Harvey and Lundblad (2000)16, we consider the liberalization effect in a small
sample of 30 emerging and frontier markets as defined by the IFC. We confirm many ofthe
results present in the literature. For example, we only observe convergence (a
negative coefficient on initial GDP) when variables controlling for long-run per capital
GDP are included in the regression. We also observe that many variables have the wrong
sign and seem to lack robustness across specifications, confirming the analysis in Levine
and Renelt (1992)17. One variable delivers a consistently positive and mostly
statistically significant coefficient: the liberalization indicator variable. Taken by itself,
financial liberalization leads to an increase in average annual per capita GDP growth of
anywhere from 1.5% to as large as 2.3 % per year. When we factor in a host of other
variables that might also boost economic performance, improvements associated with
financial liberalization still remain strong, 0.7 to 1.4% per year.
In Bekaert, Harvey and Lundblad (2001)18, we greatly expand our sample to 95 countries,
which now also include countries that may not even have financial markets, as well as
developed countries. The liberalization effect now has a cross-sectional component,
measuring the difference in growth between segmented and financially open countries, in
addition to the temporal dimension (countries before and after liberalization). It is this
cross-sectional dimension that has been the main focus in the trade openness literature.
The expansion of our sample of countries strengthens our results. In examining a number
of different samples (whose size depends on the availability of control variables), the
financial liberalization effect is robust. We also consider an alternative set of
liberalization dates. The main results are robust to these alternative dates. Further, we
carry out a Monte Carlo experiment whereby one country's liberalization date is
randomly assigned to another country. This allows us to test whether we are picking up
some overall growth effect in the late 1980s and early 1990s (when the liberalization
dates are concentrated). The Monte Carlo exercise shows that the liberalization dates are
not useful explanators of economic growth when they are decoupled from the specific
country to which they apply. We also show that the effect is not related to the world
business cycle during these years.
5. The channels of growth
a) Components of GDP
In Bekaert, Harvey, and Lundblad (2001)19, we attempt to discover what drives the
liberalization effect. To do so, we first confirm the results in Bekaert and Harvey
(2000a) and Henry (2000b), showing that investment to GDP actually increases. We
also find evidence that consumption to GDP does not increase after liberalization.
Indeed, in a number of specifications, consumption significantly decreases. Given
that we establish that GDP growth increases, the claims about frivolous consumption
and inefficient investment cannot be generally true. We find that the trade balance
decreases across all specifications. Both imports and exports increase after financial
liberalizations - but imports increase more than exports. Interestingly, in our broadest
sample, we find evidence of a smaller government sector after liberalization.
However, in our analysis with more limited samples, there is little evidence that afinancial
liberalization is associated with a change in the size of the government
sector. In the remainder of the paper, we try to determine what variables capture the
liberalization effect.
b) Financial liberalization and macroeconomic reforms
It is possible that financial liberalizations typically coincide with other more macrooriented
reforms (see Henry (2000a)20) which provide the source of increased growth
-- not the financial liberalizations. However, when we add variables capturing macroeconomic
reforms, such as inflation and trade openness, the liberalization effect is
mostly not affected.
c) Financial liberalization and financial market development
A second possibility is that financial liberalization is the natural outcome of a
financial development process, and that, consistent with many endogenous growth
theories, it is financial development that leads to increased growth. However, when
we add a number of banking and stock market development indicators to our
regressions, the liberalization effect is only marginally reduced. Moreover, we find
that financial liberalization strongly predicts additional financial development, but
that the decision to liberalize does not seem to be affected by the degree of financial
development. Hence, it is likely that one channel through which financial
liberalization increases growth is through its impact on financial development.
d) Financial Liberalization and the Cost of Capital
A third possibility is that the growth effect is a pure cost of capital effect.
Unfortunately, the cost of capital effect is very difficult to measure for various
reasons. First, as Bekaert and Harvey (1995)21 and Bekaert, Harvey and Lumsdaine
(2000b)22 stress, liberalization induces a structural break in most financial data,
making the use of a financial model to measure the change in the cost of capital
postliberalization
very difficult. We use two imperfect proxies. Our first is the dividend
yield minus its mean before liberalization (to capture cross-country differences in tax
regimes). Bekaert and Harvey (2000a)23 argue that the change in the dividend yield is
a good measure of the permanent price effect that induces the lower cost of capitalliberalization
effect goes down, but not by much. The credit rating variable does have
the expected sign and is highly significant.
e) Functional capital markets
A final possibility acknowledges the imperfection of capital markets, which drives a
wedge between the cost of internal and external capital (see for example, Hubbard
(1998)25 or Gilchrist and Himmelberg (1998)26), and makes investment sensitive to
the presence of cash flows. Foreigners may demand better corporate governance that
in turn reduces the wedge between external and internal costs of capital and drives up
investment. Our instrument to capture this is a variable constructed by Bhattacharya
and Daouk (2000)27, who trace the implementation and enforcement of insider trading
laws in a large number of countries. We find that the enforcement of insider trading
laws has a positive effect on growth and is statistically significant in three of our four
largest samples. Importantly, it does not diminish the impact of financial
liberalizations on economic growth. Another reason to suspect that corporate
governance matters for growth prospects is that we find larger liberalization effects
for countries with an Anglo-Saxon legal system. La Porta et al. (1998) analyze the
link between corporate governance and legal systems.28
Conclusions
Numerous papers have examined the determinants of growth. Much analysis has focussed
on the role of macroeconomic reforms and the development of the financial sector. Our
research program has a simple message. It is not just the existence of capital markets that
is important for growth prospects - it is crucial that these capital markets are liberalized to
allow both foreign investors to participate and local investors to diversify their portfolios
across borders.
Our research initiative shows that the financial liberalization effect is not subsumed by
economic reforms or proxies for the development of capital markets and financial
intermediation.
It is remarkable that no one before us has examined the impact of financial market
liberalizations on growth prospects. Indeed, we conducted a simple experiment to assess
the economic impact of liberalization. We considered a hypothetical country that moved
from the 25th percentile to the median in the cross-sectional distribution of the variables
that are usually associated with economic growth. For example, we suppose that a
country jumps from the 25th percentile of secondary school enrollment to the median. We
also assume that the country experiences a financial liberalization. Given the results of
our estimation, the financial liberalization alone contributes 30% of the total increased
growth. This is a very substantial contribution - especially considering the dramatic
assumption of a quartile advance in other variables associated with economic growth.
after liberalization. However, it may also measure improved growth opportunities.
When we add the modified dividend yield to our explanatory variables, we find the
liberalization effect is unaffected. The dividend yield variable has the right sign
(decreases in the cost of capital lead to more economic growth), but it is only
marginally significant.
Our second proxy for the cost of capital is the credit rating of the various countries.
Erb, Harvey and Viskanta (1996)24 argue that this measure captures the cross-section
of expected returns well, especially in emerging markets. Unfortunately, it is also aFinally, the
conditional convergence effect documented in the literature is much stronger
once you allow for a financial liberalization. Our results suggest that a financial
liberalization allows many countries to join the convergence club much faster.
Our work on understanding the channels of economic growth has just begun. We believe
the next step is to examine firm level data. With these data, we will be able to more
closely examine the response of investment and capital structure to financial
liberalization. With firm specific expected cash flows, we will be able to disentangle the
cost of capital and growth opportunity effects after financial liberalizations.
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25 Hubbard, G., 1997, Capital Market Imperfections and Investment, Journal of Economic Literature 36, 3.
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growth in numerous studies. When we add the credit rating to our regressions, the26 Gilchrist, S. and
C. Himmelberg, 1998, Investment, Fundamentals and Finance, NBER Macroeconomics
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27 Bhattacharya, U. and H. Daouk, 2000, The World Price of Insider Trading, Journal of Financial
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