Economic Growth and Financial Liberalization

Article excerpt

From 1980 to 1997, Chile experienced average real GDP growth of 3.8 percent per year while the Ivory Coast had negative real growth of 2.4 percent per year. Why? Attempts to explain differences in economic growth across countries have taken center stage in the macroeconomic literature again. [1] Although there is no agreement on what determines economic growth, most of the literature points out 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). Jeffrey Sachs and Andrew Warner [2] have argued that policy choices, such as respect for property rights and open international trade, are important determinants of long-run growth.

Campbell R. Harvey [*]

There are some interesting differences between the two countries we mentioned. First, the Ivory Coast has a larger trade sector than Chile, but the role of trade openness remains hotly debated. [3] Second, Chile liberalized its capital markets, in particular its equity market, to foreign investment in 1992. After the liberalization, it grew by 6.4 percent a year. The 1980s and 1990s witnessed a number of financial liberalizations. Given the recent currency crises and their adverse economic consequences, what is the role of financial liberalizations and foreign capital flows in the economic welfare of developing countries? What effect did they have on growth? Our recent work with Christian Lundblad tries to answer this question.

Why Would Financial Liberalization Affect Economic Growth?

There are a number of channels through which financial liberalization may affect growth. First, foreign investors, enjoying improved benefits of diversification, will drive up local equity prices permanently, thereby reducing the cost of capital. We and Peter Henry [4] show that the cost of capital goes down after major regulatory reforms. Writing with Robin L. Lumsdaine, [5] we also show that a capital inflow leads to a permanent positive effect on equity prices. Moreover, our work and Henry's [6] indicates that investment increases. If this additional investment is efficient, then economic growth should increase. However, in the aftermath of the recent crises some economists feel that foreign capital has been wasted on frivolous consumption and inefficient investment, undermining the benefits of financial liberalization.

Second, there is now a large literature on how improved financial markets and intermediation can enhance growth [7] and how financial liberalization may promote financial development. Furthermore, foreign investors may also demand better corporate governance to protect their investments, reducing the wedge between the costs of external and internal financial capital, and further increasing investment. [8]

Measuring the Liberalization Effect on Economic Growth

Most of the literature on growth implements purely cross-sectional techniques for measuring growth. The nature of our question forces us to introduce a temporal dimension into the econometric framework. In work with Lundblad, [9] 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 three years to five years, on a number of predetermined determinants of long-run steady state per capita GDP, including 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 an indicator of liberalization based primarily on the analysis of regulatory reforms in our most recent work. [10]

To maximize the time-series content in our regressions, we use overlapping data. …