Financial openness and capital mobility: a dynamic panel analysis

Abstract

Does unrestricted control on the movement of capital increase capital mobility? Theoretically, the answer is yes. This paper uses the Feldstein–Horioka savings–investment methodology to examine the impact of financial openness on the degree of capital mobility in 104 countries. Our estimates suggest that financial openness has increased capital mobility in developing countries, while its effect is statistically insignificant in OECD countries. This also implies that a developing country with more financial openness can have more access to external capital markets for borrowings. Foreign aid also appears to supplement domestic savings for investment in developing countries. In line with the previous findings, our study also confirms that capital is more mobile for developing countries.

Keywords:

• Feldstein–Horioka
• capital mobility
• financial openness
• dynamic panel

JEL Classifications:

• F21
• O17

Acknowledgments

The authors gratefully acknowledge the invaluable comments and suggestions of Ronald Balvers, Arabinda Basistha, James Irwin, Jason Taylor and an anonymous referee of this journal.

Notes

1. Later research using the methodology of FH finds high savings–investment correlation for developed countries and low correlation for developing countries (Dooley, Frankel and Mathieson 1987; Wong 1990; Mamingi 1997; Vamvakidis and Waczairg 1998; Coakley, Kulasi and Smith 1999; Kasuga 2004). Sinha and Sinha (2004) examine capital mobility for developed as well developing countries and find that capital is more mobile for countries with a low per capita income.

2. Younas and Chakraborty (2010) conclude that economic globalization has increased capital mobility in both developed as well as developing countries over time.

3. Despite the advantage of this technique over OLS, instrument variables and panel estimator, dynamic panel GMM has hardly been used to study capital mobility under FH specification.

4. One may plausibly argue that savings is endogenous as it not only affects but may also be affected by investment. Therefore, in order to get consistent estimate we need to employ two‐stage least square (2SLS) method. The problem with this approach is the non‐availability of valid instruments and data for the developing countries. Isaksson (2001) used government consumption expenditures and dependency ratio (sum of the population ages between 0 and 14 years and 65 years and above divided by labor force of a country) as instruments for the savings rate. However, they are not valid instruments in our study due to their very weak correlation with the savings rate.

5. In the presence of fixed effects, the lagged endogenous determinants will correlate with the error term, resulting in biased and inconsistent estimates for a panel with large cross‐sections and short time periods.

6. For every regression, we also checked the conditions of both validity of instruments and the absence of serial correlation in residuals.

7. Isaksson (2001) points out two reasons for using gross savings over net savings: (1) it is gross savings that moves between countries; and (2) the accounting definitions of depreciation differs across countries.

8. Gross fixed capital formation, as defined in World Bank (2007), consists of outlays on additions to the fixed assets of the economy, net changes in the level of inventories, and net acquisitions of valuables. Past studies consistently use gross fixed capital formation as a measure of investment because it does not include highly procyclical components of inventories (Bayoumi 1990; Sinha and Sinha 2004; Payne and Kumazawa 2005; Younas 2007).

9. We call the coefficient on savings rate the savings–retention coefficient because its magnitude shows the extent to which an increase in domestic savings is used to finance domestic investment.

10. Data for all variables over the time period 1970–2004 is broken into separate five‐year data averages.

11. This was expected due to negative correlation between savings rate and foreign aid variables.

12. The mean, minimum and maximum values of financial openness index in our study are: full sample (−0.04, −1.9 and 2.6); OECD countries (1.07, −1.8 and 2.6); and developing countries (−0.37, −1.9 and 2.6).