Academic journal article Journal of Southeast Asian Economies

Capital Account and Foreign Direct Investment Policies in the Late Nineties: What Effect on Trade?

Academic journal article Journal of Southeast Asian Economies

Capital Account and Foreign Direct Investment Policies in the Late Nineties: What Effect on Trade?

Article excerpt

I. Introduction

During the last three decades, international investment has been growing at over twice the rate of international trade. Yet, as with trade, the general public does not perceive intertemporal investment and other forms of asset transactions with foreigners as being welfare enhancing. For example, a recent Associated Press poll revealed that three out of five Americans were in favour of restricting foreign capital flows, and over half of all respondents agreed that foreign investment in the United States was "dangerous" (Scheve and Slaughter 2001). This negative sentiment towards international investment is pervasive worldwide as indicated by the many financial barriers that remain on foreign direct investment, foreign asset flows, and multinational bank lending (Bank of International Settlements 2001; UNCTAD 2001).

Research on the relationship between international investment and macroeconomic factors like economic growth and international trade are still in the early stages. The main problem is that researchers are faced with a lack of historical data and evidence. It was not until the 1980s that many countries started to dismantle the barriers to international investment that were erected before and after World War II. Moreover, the "deepening" of international investment to include many more types of assets like foreign direct investment (FDI) and international equity is a recent phenomenon; it was only twenty years ago when nearly all of the international financing was in the form of bonds or bank lending.

With the return of greater international investment, the risks of default and sudden reversal of investment flows have also grown. For example, in the early 1990s capital flows to developing countries rose to new heights, but defaults and sharp changes in capital flows to Mexico in 1994, a number of East Asian countries in 1997, Brazil in 1998, Russia in 1999, and Argentina in 2001 have caused concern about the volatility of unregulated international investment markets. It is not surprising that despite the potential welfare gains from international capital flows, there are frequent calls to manage the international investment sector.

Despite these challenges, economists have discovered several benefits from international investment. Several studies document the positive effects of international investment on technological progress (Romer 1993; Moran 1998; Aitken and Harrison 1999), savings and investment allocation (Feldstein and Horioka 1980), economic growth (De Long and Summers 1991; King and Levine 1993; Borensztein, De Gregorio, and Lee 1998; Temple 1998), and asset diversification (French and Poterba 1991 ; Obstfeld 1994). But there is little empirical evidence on how capital account policies impact international trade. Early empirical evidence examining the relationship between capital controls and trade use imperfect measures of financial policy such as black market premium (Lee 1993). More recent studies include: Tamirisa (1999) who in a cross-section study finds that exchange and capital account controls significantly reduce exports, especially into developing and transitioning economies; Rose (2000) and Rose and van Wincoop (2001) who show that common currency unions have a substantial positive effect on trade; and the IMF (2002) who find that "balance of payments restrictiveness" reduces bilateral trade flows.

The purpose of this paper is to empirically test the relationship between capital account liberalization and total trade (exports plus imports) flows for seventy-four countries during the 1995-2000 time period with a special focus on ASEAN economies. Using two capital account policy indices (one to measure overall capital account openness and the other to capture foreign direct investment policy), an augmented gravity model is applied to find the quantitative effect of financial liberalization on total trade volume. This study employs non-linear least squares cross-section and panel data methods. …

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