The purpose of this paper is to examine the effect of financial liberalization on the economic growth in emerging markets. It is found that economic growth responds differently to each financial sector’s liberalization. Liberalization in banking sector improves banking system efficiency, and stimulates investment, but also raises the proportion of non-performing loans. Stock market liberalization reduces cost of capital and promotes efficient capital allocation. Nevertheless, informational asymmetry in stock market increases the probability of market failure. Capital account liberalization leads to greater capital accumulation, higher employment and technology transfer, but also causes volatility, current capital account deficits and high inflation. The paper concludes by suggesting a more comprehensive assessment needs further research to capture more institutional and political implications.
Keywords: financial liberalization; economic growth; emerging markets.
From neoclassical perspective, financial liberalization deepens the development of domestic financial system, improves efficiency, attracts foreign investment and optimizes capital allocation, thus has positive effect on economic growth. However, financial crises in developing economies during late 1990s and recent subprime crisis draw the re-consideration on relationship between financial liberalization and economic growth, particular in the context of emerging markets. This paper reviews the theoretical literatures and empirical studies from 1973 to 2010, in order to provide a panoramic view of academic debate on this topic in an organized way.
The effect of financial liberalization on economic growth depends on the nature as well as the degree (partial or full) of financial sectors liberalization. In banking sector, interest rate and credit deregulation, openness of domestic banking markets, and reduction of financial restriction, together increase efficiency of banking system, which in turn, stimulate investment and economic growth. However, banking system liberalization also tends to increase financial risks with high proportion of non-performing loans. In stock market sector, reduced cost of capital, improved corporate governance, and enhanced financial development spur the economic growth. However, distortions like informational asymmetries affect growth adversely. In capital account sector, increased capital inflow, greater foreign firm entry and FDI lead to greater capital accumulation, higher employment, technology transfer and knowledge spillover, thus, facilitate economic growth. However, volatility of capital flow, current capital account deficits, and incurred high inflation imply negative growth effect.
This paper assesses liberalization in each sector through theoretical explanation with empirical evidences support. It is found that economic growth responds differently to each financial sector’s liberalization in emerging markets. Financial liberalization’s positive impact on growth is dependant on the economic development level, the quality of domestic institutions, macroeconomic policy and so on. Literatures with implication on institutions and policy are in shortage. Therefore, the paper concludes by suggesting a more comprehensive assessment needs further research to capture more institutional and political indicators.
Table of Contents
Financial liberalization concept was first raised in 1970s. Mckinnon (1973) and Shaw (1973) claim that domestic financial liberalization (financial deepening) spurs economic growth. Following researches mostly support that financial liberalization has positive effect on economic growth. It is believed that financial liberalization accelerates the process of capital absorption and efficient capital allocation, thus stimulate economic growth. Between the 1960s and mid-1990s, East Asia featured sustained and rapid growth, with impressive structural change in financial sectors (Asian Development Bank, 1997). However, after the emerging market currency crises (Mexico in 1994, Southeast Asia in 1997 and Russia in 1998), researchers have debate on the effect of financial liberalization on economic stability and growth.
Neoclassical school defines financial liberalization as elimination of interest rate control, privatization of nationalized banks and government interference in banking system (Beim and Calomiris, 2001). The other academic strand refers financial liberalization to financial openness, which focuses on capital account and equity market, for example, lowering of foreign investment barriers, facilitation and encouragement of capital flows (Bekaert, 1995), allowing inward and outward foreign equity investment (Bekaert and Harvey, 2000). Henry (2003) argues that strictly speaking, equity market liberalization is a specific type of capital account liberalization, which is the decision to allow capital in all forms to move freely in and out of the domestic market.
Researchers review the effects of financial liberalization (banking system, stock market and capital account) on economic growth continuously. A large line of research work provides evidence that development of a financial system is a key driver of economic growth (Levine, 1991; King and Levine, 1993; Levine and Zervos, 1996, 1998; Levine et al., 2000; Demirguc-Kunt and Maksimovic, 1996; Rajan and Zingales, 2001; Rousseau and Sylla, 1999, 2003; Bekaert et al., 2002, 2003). Although mainstream academic study claims the positive relationship between financial liberalization and economic growth, the growth effect is mainly driven by developed countries (Edwards, 2001; Klein, 2003; Klein and Olivei, 2008). It is still worth to note that economic growth responds differently to each financial sector’s liberalization, especially in the context of emerging markets. Edison et al. (2002), Chandra (2003) and Arteta et al. (2003) suggest that the growth effect hypothesis in emerging markets is mixed and fragile.
This paper provides a comprehensive literature review by using the theoretical and empirical work available from 1973 to 2010, in order to examine the effect of financial liberalization on the economic growth in emerging markets. Three financial sectors: banking system, stock market, and capital account would be examined respectively. The structure of this paper is organized as follows: Section 1 examines the liberalization in banking system with relevant theories discussion and empirical evidences support. Section 2 examines the stock market with theory and empirical study. Section 3 includes the theory and empirical work on capital account liberalization. Section 4 concludes and proposes future research direction.
Section 1: Banking
From a neoclassical perspective, domestic financial liberalization’s effects are expected to facilitate economic growth (Rajan and Zingales, 1998; Love, 2003; Laeven, 2003). The theoretical explanation follows the rationale that reform increases efficiency, efficiency leads to growth. First, investment becomes efficient after liberalization. Elimination of interest rate control and credit deregulation directly remove financing constraints, stimulate bank lending, improve capital allocation, thus increase investment’s quantity and efficiency (Beim and Calomiris, 2001). Second, banking system itself becomes efficient. Opening banking markets (i.e. privatization of nationalized bank, introduction of foreign bank competition) improves the functioning of national banking systems and the quality of financial services, which has positive implication for banking customers (Claessens et al., 2001). Leaven (2003) concludes that banking liberalization reduces financial restrictions, increases efficiency, stimulates investment, thus, incurs economic growth.
However, deregulation of domestic banking system also tends to increase financial risks and to worsen the quality of loans. Interest rate and credit deregulation allow banks with hazard moral and not constrained by an effective prudential regulation, to invest in risky assets in order to maintain larger market share (Hellmann et al., 2000). This reduces asset’s quality that in turn results in a higher proportion of non-performing loans and provision for doubtful debts. Under such conditions, efficiency and growth are both adversely affected. Moreover, the high cost of acquiring information about local firms may limit foreign banks to ‘cream-skimming’, where they lend only to the most profitable local firms (Petersen and Rajan, 1995; Dell’ Ariccia and Marquez, 2004; Sengupta, 2007) and adversely affect firms that want to get credit from them (Detragiache et al., 2008; Gormley, 2007, 2010).
Empirical studies suggest that partial liberalization in banking sector is associated with positive growth effects but full liberalization is associated with negative growth effects (Gamra, 2009). Yang and Yi (2008) show that partial banking sector liberalization is beneficial for East Asian economic growth. During the first phase of liberalization, an expansion of the financial cycle marked by a development of financial intermediation and a financial deepening, keep temporarily high economic growth rate (McKinnon and Pill, 1997). This has been particularly the case in East Asian countries, which have achieved virtual steady growth with high saving and very high investment, during 1980s and the beginning of 1990s. Nevertheless, full liberalization of banking sector is harmful for emerging East Asian countries. This finding is essentially justified by the occurrence of financial crises, whose economic costs are exorbitant. The banking crises costs of 1997, for example, reached 55% of GDP in Indonesia, 35% in Thailand, and 28% in Korea (Caprio and Klingebiel, 2003). This implies that the full financial liberalization of late 1990s, may explain both financial crises and growth decline in East Asian countries.
Section 2: Stock market
Stock market liberalization could spur economic growth in two ways. First, it reduces cost of capital through wider risk sharing (Stulz, 1999), fosters domestic stock market development (De La Torre et al., 2007), which, in turn, leads to investment booms (Henry, 2000) and thus spurs economic growth (Bekaert et al., 2005; Moshirian, 2008). If equity markets are imperfect, external capital is likely to be more costly than internal capital and a shortage of internal capital would reduce investment below optimal levels. Equity market liberalizations give foreign investors the opportunity to invest in domestic equity securities and domestic investors the right to transact in foreign equity securities. Improved risk sharing post-liberalization should decrease the cost of equity capital (Bekaert and Harvey, 2000; Henry, 2000; Chari and Henry, 2004) so as to increase investment. Second, liberalization improves legal environment and investor protection, which is a source of the growth prospects. Foreign investors may insist on better corporate governance and investor protection (La Porta et al., 1997; Ciner and Karagozoglu, 2008), which indirectly reduces the gap between internal and external finance cost, promote financial development (King and Levine, 1993; Kim and Shamsuddin, 2008), and hence growth.
However, stock market liberalization is also simultaneously viewed as a source of financial instability, especially of financial markets crises. It is argued that distortions embedding in stock market weaken the growth effect, such as information asymmetries. Stiglitz (2000) explains that informational asymmetries prevent foreign capital to be profitably invested, and affect adversely growth.
Large amount of empirical studies (Atje and Jovanovic, 1989; Demirguc-Kunt and Levine, 1996; Demirguc-Kunt and Maksimovic, 1996, and Levine and Zervos, 1996) examine the effect of stock market development on economic growth and indicate a positive relation between these two variables. Particularly, Bekaert et al. (2005) reveal that stock market liberalization spurring economic growth, and the link between these two variables is robust, direct, and instantaneous. On average, they find that stock market liberalization leads to a 1% increase in annual per capita GDP growth, over five-year periods, and that this effect is statistically significant, over the period 1980 to 1997. They stress the robustness of this result, with respect to different countries groupings (emerging markets included), and different time horizons for measuring economic growth.
Focusing on emerging markets specifically, Levine and Zervos (1998) uncover that stock markets become more liquid after liberalization in a study of 16 emerging markets. Kim and Singal (2000) study the impact of market opening in emerging markets and find that the benefits are likely to outweigh the perceived risks associated with foreign portfolio flows. Clark and Berko (1997) (focusing on Mexico) and Froot et al. (2001) (focusing on 28 emerging markets) find that increases in capital flows raise stock prices, but studies disagree on whether the effect is temporary or permanent. If the increase in prices is temporary, it may be just a reflection of ‘‘price pressure” which has also been documented in developed markets for mutual fund flows and stock indices (Warther, 1995; Shleifer, 1986). If the price increase is permanent, it may reflect a long-lasting decrease in the cost of capital associated with the risk-sharing benefits of stock market openings in emerging markets. On country level, Fuchs-Schundeln and Funke (2001) find strong evidence supporting the hypothesis that equity market liberalization enhances economic growth among 27 emerging markets, over a long period 1975–2002. LS (least squares) tests indicate that stock market liberalization contributes to a 4% increase in annual per capita GDP growth in the five years following liberalization. Schuppli and Bohl (2010) draw similar conclusion on China case. On industry level, Gupta and Yuan (2009)’s research show that industries depending more on external finance experience significantly higher growth following liberalization. On the firm level, Galindo et al. (2007) and Abiad et al. (2008) find that stock market liberalization improves the efficiency of capital allocation for firms in emerging markets. Individual firms experience reductions in the costs of capital post-equity market liberalization in emerging markets (Chari and Henry, 2004).
Section 3: Capital account
Capital account liberalization reduces capital flow constraints and removes trade barriers. Consequently, the increased capital inflow, greater foreign firm entry and FDI lead to greater capital accumulation and higher employment, thus higher growth (Dollar, 1992; Lee 1993; Edwards, 1998; Sachs and Warner, 1995; Wacziarg and Welch, 2008). Domestic capital account liberalization attracts international portfolio investment inflow. The portfolio investment approaches efficient frontier, and more importantly, it contributes to improve the efficiency of domestic financial market, thus financial development (Prasad et al., 2003; Cajueiro et al., 2009). Moreover, foreign direct investment can facilitate the transfer of technological and managerial knowhow, in turn, improves domestic R&D capability (Ang and Madsen, 2008; Ang, 2009). Recent work on endogenous growth theory suggests that R&D effort is important determinant of long-run growth (De la Fuente and Marín, 1996; Blackburn and Hung, 1998; Aghion et al., 2005; Aghion and Howitt, 2009).
However, alternative theories imply negative growth effect after capital account liberalization. First, capital flows, particular short-term flows, are often volatile and subject to surges and sudden withdrawal (Bae et al., 2004; Singh, 2002; Li et al., 2004; Stiglitz, 2004). Stiglitz (2000) argues the openness of an emerging market increases uncertainty, thus making investment less attractive and facilitating capital flight. Bohn and Tesar (1996) argue that international investors are momentum investors (i.e. return chasers), which causes the volatility in foreign capital flow. Capital inflows did wane in late 1996 and early 1997 leading to financial crises marked by a dramatic increase in non-performing loans, weakening of bank balance sheets, deterioration of investment quality and a deep economic contraction (Radelet and Sachs, 1998). The World Bank estimates that in 1999 the output of five crises countries in East Asia was 17% below the previous pre-crisis trend path. Second, capital inflows can lead to an appreciation of domestic currency and adversely affect the trade balance (unsustainable current account deficits). Third, large and sudden inflows can fuel rapid consumption growth, raise or sustain high inflation (Fischer et al., 1997), and there is a significant negative relation between inflation and economic growth (Barro, 1997a, b).
Quinn (1997)’s empirical study identifies a positive effect between capital account liberalization and economic growth. His empirical estimates use a cross-section of 58 countries, over the period 1960 to 1989. Result suggests that the change in capital account liberalization has a strongly significant effect on real per capita GDP growth. Arteta et al. (2003) assessed the robustness of Quinn’s result. They employed the same indicator of liberalization on pooled data of 51 to 59 countries, over three periods of analysis 1973–1981, 1982–1987, and 1988–1992. Tests confirm a first order positive relationship between capital account liberalization and economic growth. Klein and Olivei (2008) also find that economies that had more open capital markets during 1976–2005 experienced relatively higher rates of growth. Furthermore, Quinn and Toyoda (2008) use data for 94 nations and a period from 1954 to 2004 and find positive association of capital liberalization with growth in both developed and emerging markets.
On the contrary, Grilli and Milesi-Ferretti (1995), Rodrik (1998), Kraay (2003) and Calderon et al., (2004) claim that no correlation exists between capital account liberalization and growth prospects. Grilli and Milesi-Ferretti (1995) find no association between capital account liberalization and economic growth. Their study covers the period 1966–1989, and includes 61 countries. Using data for a broad sample of 100 developed and developing countries and controlling for other growth determinants, over the period 1975–1989, Rodrik (1998) concludes that capital account liberalization is essentially uncorrelated with long-run economic performance. Kraay (2003) undertakes a more comprehensive examination of capital account liberalization’s effect on investment, growth, and inflation. His study includes data from 117 countries, over the period 1985–1997. The correlations between capital account liberalization and growth are found to be weak. Calderon et al. (2004) confirm the existence of a nonlinear relationship between income growth and openness, with sample of 76 countries over the period 1970–2000.
Focusing on emerging markets specifically, Edison et al. (2002), Eichengreen (2002), Chandra (2003) and Arteta et al. (2003) suggest that the growth effect hypothesis in emerging markets is mixed and fragile. De Santis and Imrohoroglu (1997), Hargis (2002) and Kim and Singal (2000) find either a negative or no impact of financial liberalization on volatility. Klein and Olivei (1999) find that economies that had more open capital account during 1976–1995 experienced relatively higher rates of growth. However, this result is largely driven by the developed countries in a heterogeneous sample of 82 countries. Quinn et al. (2001) also prove that capital account liberalization’s benefits are restricted to more developed countries rather than emerging markets. Moreover, Edwards (2001) notes a positive effect that is driven by the higher income countries in his test. Particularly, Klein (2003) finds an inverted U-shaped effect: capital account liberalization has no impact on the poorest and the richest countries but a substantial impact on the middle-income countries. He proves that liberalization exerts a positive effect on growth only in medium income countries. In low and high income countries, liberalization remains insignificant.
This paper examines liberalization in banking, stock market and capital account sector and concludes that economic growth responds differently to each financial sector’s liberalization in emerging markets. The effect of financial liberalization on economic growth depends on the nature as well as the degree (partial or full) of financial sectors liberalization.
In banking sector, interest rate and credit deregulation (Beim and Calpmiris, 2001), openness of domestic banking markets (Claessens et al., 2001), reduction of financial restriction (Leaven, 2003) increase efficiency of banking system, thus stimulate investment and economic growth. Although banking system liberalization tends to increase financial risks with high proportion of non-performing loans (Hellmann et al., 2000), empirical evidences support significant positive growth effect of domestic financial liberalization (banking sector) in emerging markets (Love, 2003; Laeven, 2003), however, with the condition that partial liberalization is associated with positive growth effects but full liberalization is associated with negative growth (Gamra, 2009).
In stock market sector, reduced cost of capital (Bekaert and Harvey, 2000; Henry, 2000), improved corporate governance and investor protection (La Porta et al., 1997), and enhanced financial development (King and Levine, 1993) spur the economic growth. However, distortions like informational asymmetries (Stiglitz, 2000) affect growth adversely. Empirical evidences show positive relationship between stock market liberalization and economic growth (Atje and Jovanovic, 1989; Demirguc-Kunt and Levine, 1996; Demirguc-Kunt and Maksimovic, 1996; Levine and Zervos, 1996, and Bekaert et al., 2001, 2003, 2005). Positive relationship is also robust in emerging markets, on country level (Levine and Zervos, 1998; Froot et al., 2001, and Fuchs-Schundeln and Funke, 2001), on industry level (Gupta and Yuan, 2009), and on firm level (Galindo et al., 2001; Chari and Henry, 2004), respectively.
In capital account sector, increased capital inflow, greater foreign firm entry and FDI lead to greater capital accumulation, higher employment and technology transfer (Dollar, 1992; Lee 1993; Edwards, 1998; Sachs and Warner, 1995; Wacziarg and Welch, 2008), plus international portfolio investment improves the efficiency of domestic financial market (Prasad et al., 2003), facilitate economic growth. However, volatility of capital flow (Radelet and Sachs, 1998; Stiglitz, 2000), current capital account deficits, and incurred high inflation (Barro, 1997; Fischer et al., 1997) imply negative growth effect. Although some empirical studies suggest positive relationship between capital account liberalization and economic growth (Quinn, 1997; Klein and Olivei, 1999; Arteta et al., 2001), other studies find no correlation exists between capital account liberalization and growth prospects (Grilli and Milesi-Ferretti, 1995; Rodrik, 1998; Kraay, 2003; Calderon et al., 2004). Particularly, Edison et al. (2002), Eichengreen (2002), Chandra (2003), and Arteta et al. (2003) suggest that the growth effect hypothesis in emerging markets is mixed and fragile. Klein and Olivei (1999), Edwards (2001) and Inclan and Toyoda (2001) claim that positive growth effect in many empirical studies is mainly driven by developed countries rather than emerging markets.
Financial liberalization’s benefits are broadly conditional. Its positive impact on growth is dependant on the economic development level, the quality of domestic institutions, macroeconomic policy and so on. Empirical studies with implication on institutions and policy are in shortage. The US subprime crisis in 2007 implied the importance of financial regulation on financial institutions and markets (Mendoza and Quadrini, 2010). Future research is suggested to capture more indicators referring to institutional and political conditions, especially, with the implication of US subprime crisis.