Overall effects of financial liberalization: financial crisis versus economic growth

ABSTRACT

The contribution of this work consists firstly in decomposing the effect of financial liberalization into a global direct positive effect on growth and an indirect negative effect via financial fragility and crisis. We show that the aggregate positive effect of financial liberalization outweighs the negative partial or temporary effect. Secondly, contrary to previous works, we distinguish many types of financial reforms. We found that equity market liberalization is the most important component in reducing economical costs associated with financial crisis. Thus, equity market liberalization is the most important favoring growth. Interest rate liberalization enhances significantly the probability of crisis leading to a short-run indirect effect more important than other financial reforms. Thirdly, we improved our work by addressing model uncertainty using Bayesian Model Averaging techniques to choose appropriate indicators for model crisis specification.

KEYWORDS:

• Financial reforms
• financial crisis
• economic growth
• Bayesian model averaging
• Treatment effect model

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Beck et al. (2006).

2. See Sawyer (2014), for example, on the origins and usage of the term financialization.

3. Based on their analysis of the East Asian experience .

4. All of the emerging market economies experiencing substantial financial capital inflows experienced property and real-estate booms, as well as stock market booms, even while the real economy may have been stagnating or even declining. These booms, in turn, generated the incomes to keep domestic demand and growth in certain sectors growing at relatively high rates. This soon resulted in signs of macroeconomic imbalance, not in the form of rising government fiscal deficits, but as a current-account deficit reflecting the consequences of debt-financed private profligacy.

5. We note that GDP per capita growth is not a proxy for the social welfare but can be considered as an important indicator of the social and economic policy effectiveness.

6. Edwards (2004) uses a similar framework to assess the impact of sudden stop on growth.

7. The hazard is given by: $h_{i,t}=\left\{\begin{array}{c}\varphi \left(\hat{a}{Z}_{i,t}+\hat{b}F{L}_{i,t}\right)/\mathrm{\Phi }\left(\hat{a}{Z}_{i,t}+\hat{b}F{L}_{i,t}\right)if{I}_{i,t}=1\\ -\varphi \left(\hat{a}{Z}_{i,t}+\hat{b}F{L}_{i,t}\right)/\left(1-\mathrm{\Phi }\left(\hat{a}{Z}_{i,t}+\hat{b}F{L}_{i,t}\right)\right)if{I}_{i,t}=0\end{array}\right.$

where $\varphi$ and $\mathrm{\Phi }$ are the density and cumulative distribution of the standard normal density function.

8. Note that variables such as education and health are not considered in order to keep the simplicity of the model and avoid problems of multi-colinearity while assuming that these indicators can be reflected by government size and population growth.

9. The particular measure of government spending or consumption is intended to approximate the outlays that do not enhance productivity. Hence, the conclusion is that a greater volume of nonproductive government spending reduces the growth rate for a given starting value of GDP. In this sense, big government is bad for growth.

10. The lower the starting level of real per capita gross domestic product (GDP), the higher is the predicted growth rate. If all economies were intrinsically the same, except for their starting capital intensities, then convergence would apply in an absolute sense; that is, poor places would tend to grow faster per capita than rich ones. However, if economies differ in various respects then the convergence force applies only in a conditional sense. The growth rate tends to be high if the starting per capita GDP is low in relation to its long-run or steady-state position. For given values of the other explanatory variables, the neoclassical model predicts a negative coefficient on initial GDP, which enters in the system in logarithmic form. The coefficient on the log of initial GDP has the interpretation of a conditional rate of convergence. If the other explanatory variables are held constant, then the economy tends to approach its long-run position at the rate indicated by the magnitude of the coefficient.

11. If the population is growing, then a portion of the economy’s investment is used to provide capital for new workers, rather than to raise capital per worker. For this reason, a higher rate of population growth has a negative effect on the steady-state level of output per effective worker in the neoclassical growth model.

12. Studies on inflation and growth can be traced back to the classical economists, and remains a subject of current debate. The most important aspect of the classical theory is the quantity theory of money advanced by the nineteenth-century quantitative school (and the monetarist theory of the twentieth century). It considered monetary inflation to be the result of monetary authorities issuing too much money in relation to the quantity of goods in the economic circuit. Although the relationship between inflation and economic growth is not stated clearly in the classical theory of growth, it is implicitly asserted that there is a negative relationship between the two variables. For example, Fischer (1993), Barro (1996), and De Gregorio (1993) confirm a negative link between inflation and growth. On the other hand, the most recent inflation growth theory has focused on a nonlinear relationship between inflation and growth, explained by money demand elasticity (Gillman and Kejak 2005). In the endogenous model, the relationship between inflation and growth is introduced through the marginal product of capital (physical or human) trying to determine the threshold at which inflation starts suppressing long-run growth. Most of the empirical studies have confirmed the negative and nonlinear impact of inflation, mainly beyond a certain threshold level (Bruno and Easterly 1998; Ghosh and Philips, 1998; Gylfason and Herbertsson 2001; Khan and Senhadji 2001; Munir and Mansur 2009; Odhiambo, 2012; Kremer, Bick, and Nautz 2013; Vinayagathasan 2013; Baharumshah, Slesman, and Wohar 2016). The usual arguments for lower and more stable inflation include reduced uncertainty in the economy and enhanced efficiency of the price mechanism. A reduction in inflation could have an overall effect on the level of capital accumulation in cases of tax distortions or when investment decisions are made with a long-run perspective. Moreover, uncertainty related to higher volatility in inflation could discourage firms from investing in projects that have high returns, but also a higher inherent degree of risk. The expected sign of estimated coefficient is negative.

13. The degree of international openness is measured by the ratio of exports plus imports to GDP. Hence, there is evidence that greater international openness stimulates economic growth. The expected sign of the estimated coefficient on the openness variable is positive.

14. Many studies argue that the link between exchange regime and growth exists, but the sign of the influence is blurred. The channel through which it might influence growth is trade, investment and productivity. Theoretical considerations relate the exchange-rate effect on growth to the level of uncertainty imposed by flexible option of the rate. However, while reduced policy uncertainty under a peg promotes an environment which is conductive to production factor growth, trade and hence to output, such targets do not provide an adjustment mechanism in times of shocks, thus stimulating protectionist behavior, price signal distortion and misallocation of resources. Any attempt to over-stimulate the economy, by expansionary monetary policy or currency devaluation will result in higher inflation, but no increase in growth. Relatively large exchange rate overvaluation is expected to be associated with an increased likelihood of a currency crisis because of the negative effects on competitiveness. Adverse performance of the terms of trade because of relatively high import prices erodes purchasing power and dampens domestic economic activity. Declining real GDP growth may signal worsening economic conditions and undermine investor confidence in home country investment opportunities.

15. Higher foreign reserve holdings imply greater ability to respond to speculative depreciation attacks. The ratio of M2 to reserves captures to what extent the liabilities of the banking system are backed by international reserves. In the event of a currency crisis, bank depositors may rush to convert their domestic currency assets into foreign currency; this ratio captures the ability of the central bank to meet those demands and stabilize the currency. We use M2 as a proportion of GDP to capture financial development since this captures the ability of the financial system to provide transaction services. However, several papers including Favara (2003) and Deidda and Fattouh (2002) use M3/GDP as a proxy for financial development.

16. We use a 3-year horizon because previous literature finds financial liberalization increases financial crisis and that this window is the best predictive interval for policies makers.

17. There are many sources of inflation but the most frequently advanced is the monetarist explanation such as: (1) Inflation can be imported meaning that cost increases result from higher prices for imported goods, whether raw materials, semi-finished goods or finished products; and (2) Inflation may be cost-driven if a key cost component increases. This is the case, for example, when wages increase faster than productivity (the wage cost per unit produced increases) or when raw materials or basic energy become more expensive as during the first and second oil shocks. The increase in costs is then reflected in the cost price, then in the selling price, resulting in higher prices; (3) Inflation can be induced by structural elements (or by economic and social structures) which means that price increases can be explained by price conditions in markets or economic sectors. In particular, resulting from situations of imperfect competition in industry or prices set by the public authorities in primary sectors.

18. We use these variables to take account of the potential contagion effects in interconnected financial markets (Allen, Babus, and Carletti 2009).

19. We use three different warning horizons for the BMA analysis rather than looking at the timely effect of the potential early warning indicator.

20. We use the library BMS for R developed by Zeugner (2011) and available at http://bms.zeugner.eu/.

21. According to the rule of thumb proposed by Jeffreys (1961) and refined by Kass and Raftery (1995), the significance of each repressor is weak, positive, strong, or decisive if the PIP lies between 0.5 and 0.75; 0.75 and 0.95; 0.95 and 0.99; or 0.99 and 1, respectively.

22. The estimated difference in the probability of financial crisis associated with a change of the financial liberalization index is given by $\mathrm{\Phi }\left(\hat{a}{Z}_{i,t}+\hat{b}\right)-\mathrm{\Phi }\left(\hat{a}{Z}_{i,t}\right)$. Hence, $\hat{b}>0$ means that financial liberalization increases ceteris paribus the probability of a crisis.

23. The estimated difference in the probability of a financial crisis associated with a change of the financial liberalization index is given by $\mathrm{\Phi }\left(\hat{a}{Z}_{i,t}+\hat{b}\right)-\mathrm{\Phi }\left(\hat{a}{Z}_{i,t}\right).$. Hence, $\hat{b}>0$ means that financial liberalization increases ceteris paribus the probability of a crisis.

24. See Hamdaoui (2016).

25. YSR represents the number of years since the last reform in regulation and supervision introduced to show that differential vulnerability to financial crises can be explained by asymmetry between financial markets evolution and regulation.

26. Polity is a variable that measures the Polity score, which combines the scores on the democracy and autocracy indices to a single regime indicator. The score captures the regime authority spectrum on a 21-point scale ranging from −10 (hereditary monarchy) to +10 (consolidated democracy). The components variables that are used to construct the composite indices are also published in disaggregate form (Marshall and Jaggers 2007).