Financial market development and trade openness: evidence from emerging economies

Abstract

International trade is said to be the engine of economic growth. Despite an enormous effort to explain this phenomenon, the relationship between financial market development and trade openness and integration into the world economy is still an enigma. This article investigates the relationship between financial market development and trade openness. To do this, we develop a long-run and short-run model (a bounds testing approach to cointegration) for 18 emerging economies over the period 1980 to 2011. Estimates from all models show that financial market development, including both the stock market and the banking sector, has significant effect on trade openness in both short-run and long-run phenomena in the majority of countries. Despite many similarities among emerging economies, additional evidence suggests that the link between either stock market development or banking sector development with trade openness works via each country’s specific structure.

Keywords:

• trade openness
• financial market development
• bounds testing
• emerging economies

JEL Classification:

• F13
• G28
• O16

Notes

¹ See Levine (1997, 2005) for surveys of the theoretical and empirical literature.

² The methodology we use here closely follows Bahmani-Oskooee and Tanku (2008). For other application of Bonds Testing approach to cointegration, see Bahmani-Oskooee et al. (2008) and Bahmani-Oskooee and Hegerty (2009).

³ The literature usually defines financial development as the improvement in quantity, quality and efficiency of financial intermediary services. This process involves the combination of many activities and institutions. Thus, financial development cannot be captured by a single measure.

⁴ Boyd et al. (2001) note that SMV complements SMC because it reflects the actual volume of market transactions along with the overall size of the market.

⁵ In Equation 1, if all variables are integrated of order (1), the estimated residuals must be integrated of order (0) to have cointegration.

⁶ In this model, the linear combination of lagged level variables are replaced for the lagged error-term of Engle and Granger (1987).

⁷ For more detailed explanation and derivation of this approach, see Bahmani-Oskooee and Tanku (2008).

⁸ The International Monetary Fund (IMF, 16 July 2012) labels these countries as emerging economies: Argentina, Brazil, Bulgaria, Chile, China, Estonia, Hungary, India, Indonesia, Latvia, Lithuania, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Romania, Russia, South Africa, Thailand, Turkey, Ukraine and Venezuela.