The growth effect of international financial integration evidence from cross country analysis

UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM ERAMUS UNIVERSITY ROTTERDAM INSTITUTE OF SOCIAL STUDIES THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE GROWTH EFFECT OF INTERNATIONAL FINANCIAL INTEGRATION: EVIDENCE FROM CROSS COUNTRY ANALYSIS BY HO THY DUNG Academic Supervisors: Dr DUONG NHU HUNG MASTER OF ARTS IN DEVELOPMENT ECONOMICS HO CHI MINH CITY, December 2016 UNIVERSITY OF ECONOMICS HO CHI MINH CITY VIETNAM ERAMUS UNIVERSITY ROTTERDAM INSTITUTE OF SOCIAL STUDIES THE NETHERLANDS VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE GROWTH EFFECT OF INTERNATIONAL FINANCIAL INTEGRATION: EVIDENCE FROM CROSS COUNTRY ANALYSIS By HO THY DUNG Academic Supervisors: Dr DUONG NHU HUNG HO CHI MINH CITY, December 2016 CERTIFICATION “I certify that the substance of this thesis has not already been submitted for any degree and have not been currently submitted for any other degree I certify that to the best of my knowledge and help received in preparing this thesis and all sources used have been acknowledged in this thesis.” HO THY DUNG ACKNOWLEDGMENTS First of all, I would like to express my heartfelt gratitude to Doctor Duong Nhu Hung, my supervisor His inspiration together with supports has encouraged me to complete this thesis I also take this chance to convey my sincere thanks to Doctor Truong Dang Thuy I am so appreciate to his help and enthusiasm Finally, I am deeply grateful to my family, friends, Ms Tang Thi Xuan Hong (Programme Secretary) and my colleagues for their help and sharing of their resources to complete this thesis successfully and in time Thanks so much for everything! ABSTRACT Currently, international financial integration (IFI) is a trend of the world However, there is little evidence of its positive impact on the economic growth The reasons can be error in measurement of IFI indicators, the multicollinearity among variables in model (Quinn and Toyoda, 2008) They may lead to the inconsistent results and accounts in part for larger standard errors and biased estimator Different data might also contribute to these inconsistent results The targets of this paper is to study the role of IFI on economic growth with impact of macroeconomic instability using FDI and portfolio investment capital with weighted ways to proxy for IFI With the latest annual data in the period of 19822014, the paper employs GMM method for estimating the panel-data We start by employing VIF indicators and normal distribution assumption to choose conditional variables, dropping outliers and collinearity We also provide a global picture about the economic performance of countries in the world In empirical analysis, my research finds a robust and positive statistically significant association between flow of FDI and the real GDP per capita growth The finding emphasizes the important role of IFI in enhancing economic growth We also find a weak evidence that macroeconomic instability has negative effect on the impact of IFI on economic growth Interestingly, my thesis asserts the existence of inverse linkage between money supply and economic growth This finding is sharply contrasts with conventional wisdom of many people who think that financial deepening will benefit for economic growth ABBREVIATIONS i IFI International financial integration ii FDI Foreign Direct Investment iii FE Fixed Effect Model iv RE Random effect model v GMM Generalized moment of method vi VIF Variance inflation factor vii OLS Ordinary least squares TABLE OF CONTENTS CHAPTER INTRODUCTION 1.1 PROBLEM STATEMENT 1.2 Research objectives 1.3 Research questions 1.4 Research Methodology 1.5 Organization of the study CHAPTER LITERATURE REVIEW 2.1 International financial integration 2.2 Theoretical Background underlying IFI and economic growth 2.2.1 Classical Theory 2.2.2 Exogenous Growth Theory .5 2.2.3 Endogenous Growth Theory 2.2.3.1 Learning by doing model 2.2.3.2 Research and development model 2.3 Theoretical Background relate to relationship between IFI and growth 2.3.1 Overview of relationship between IFI and growth 2.3.2 Empirical framework 11 2.4 Conceptual framework 16 CHAPTER 18 RESEARCH METHODOLOGY 18 3.1 Determinants of international financial integration 18 3.1.1 De jure measures 18 3.1.2 De factor measures 19 3.2 Data source 20 3.2.1 Measures of international financial integration 20 3.2.2 Data for variables in model 20 3.3 Model Specification 21 3.3.1 Model .21 3.3.2 Variables specification: 22 3.3.2.1 The real GDP per capita growth 23 3.3.2.2 The international financial integration .23 3.4 Methodology 26 CHAPTER 28 EMPIRICAL RESULTS 28 4.1 Overview of real GDP per capita growth in The World 28 4.2 Preliminary statistics 29 4.2.1 Descriptive statistics 29 4.2.2 Correlation of coefficients .31 4.3 Empirical result for panel data 32 CHAPTER 37 CONCLUSION AND POLICY RECOMMENDATIONS 37 5.1 Conclusion 37 5.2 Policy Implications 37 5.3 Limitation and further research 38 REFERENCE 39 APPENDIX: 41 List of 48 countries in research 41 Regression Result from Panel Data 41 Result with IFI1 and all control variables 41 Result with IFI1, adding and subtracting variables 42 Result with IFI2 and all control variables 44 Result with IFI2, adding and subtracting variables 44 Fisher test for independent variables 47 LIST OF TABLES Table 2.1: Effect of IFI on growth in 11 aspects………………………………………….8 Table 2.2: Summary of the empirical papers relate to relationship between IFI and growth ……………………………………………………………………………………….15 Table 3.1: Data for international financial integration ………………………………… 20 Table 3.2: Summary of variables in the model …………………………………… 25 Table 4.1 and 4.2: Descriptive statistics………………………………………… …….30 Table 4.3: Correlation matrix…………………………………………………………….31 Table 4.4: Fisher test with lag (1)……………………………………………………… 33 Table 4.5: Panel regression………………………………………………………………34 LIST OF FIGURES Figure 2.1: The relationship between international financial integration and economic growth……………………………………………………………………………… 17 Figure 4.1: Trend of real GDP per capita growth in the World from 1982 to 2014….… 28 Chapter INTRODUCTION 1.1 PROBLEM STATEMENT Capital have played an important role in the economic theory Adam Smith and David Ricardo have perspectives that stress on the important of capital accumulation, social capital, free trade, etc in which the economy is self-regulating and always at full-employment (Letiche, 1960) Exogenous growth theory of Slow and Swan stated that capital accumulation is one of input factors of the economy growth in long run (Solow, 1956, Swan, 1956) Arrow (1962) pointed out that specialization would affect the comparative advantage of a country And flow of capital or new investment as a source stimulate the learning by doing process Hence, both physical and human capital will increase economic growth In Cobb-Douglas function, we see that capital is also main input of the economic growth (Hall and Jones, 1996) Since the late 1980s, the world has witnessed a trend towards the deepening integration of the domestic financial markets There are many research on growth benefit of international financial integration (IFI) but they cannot provide strong evidence on this subject Then researchers tend to find out the threshold effects in the process of IFI According to their view, financial globalization will have better impacts with a certain level of some threshold conditions (Kose et al., 2006) However, majority of them show a mixed effects or no robust result while only a number of papers find a positive benefit of financial globalization (Kose et al., 2006, Kose et al., 2010) Recently, it is important to understand the impacts of IFI on growth when the trend of opening financial market generally continued over the world IFI not only lead to large benefits but can also come with crises and contagion (Schmukler, 2004) Many critics argued that IFIs’ benefits were intangible and undocumented after the Asian crisis of 1997–98 (Obstfeld, 2009) So where is the real result of the financial integration process that many countries are pursuing? In addition, are there certain conditions for the better impacts of IFI on growth? Although there are many debates, empirical research on this issue have just exploded in recent time and along many channels Ho Thy Dung / MDE K21 International financial integration statistically significant at 5% level and comes to the equation with positive sign This finding reconfirms the important role of International financial integration in strengthen the capacity to promote economic growth in the world This evidence also supports the policies of countries in boosting foreign investment flows as a way contribute to economic growth The result implies that, all other thing being equal, one percentage point increase in International financial integration is associated with an increase in GDP per capita growth 0.162 percentage point The finding is parallel with earlier study about the impact of International financial integration on economic growth (Vo, 2005, Quinn and Toyoda, 2008) There are many reasons to explain for this relationship First, risk diversification leading to more efficient investment Investors can access business opportunities with the lowest risk and highest profit Second, through the international capital and the easing of barriers to capital, domestic financial background will be improved in terms of more efficient operations and more consistent rules for investors Finally, international financial integration help allocate international resources more efficient, for those who really need it Money supply enter equation with negative sign and statistically significant at 10% level All other thing being equal, one percentage point increase in money supply is associated with a decrease in GDP per capita growth 0.012 percentage point This result is opposite with our expectation There are many reasons to explain for this relationship First, the result can be the misallocation of capital when too much liquidity in market It leads to burst bubbles and recession Second, in long run, money supply is reason of higher price than its price normally because the surplus of liquidity We achieve insignificant result for three variable inflation, interaction term and lag of GDP per capita but the sign is same with our expectation for variable inflation and lag of GDP per capita With this result, we cannot conclude that macroeconomic instability does not affect to impact of IFI on economic growth Instead, this aspect may limit to find out in base on data of this research In general, findings contribute to study that international financial integration promote economic growth About positive effect of the development of the domestic financial system on economic growth, we have conflicting results This may be Ho Thy Dung / MDE K21 35 consequence of financial crisis in research time because countries with high level of development of financial systems will be more affected by the crisis In column (2), we shows the results of research model with total stock of FDI and portfolio investment represent IFI We regress Y as a function of five variables as lag of GDP per capita, international financial integration, financial deepening, inflation, interaction term of Y and M2a We found that only one variable significant Lag of GDP per capita growth, international financial integration have signs in accordance with our expectations although they are not significant in this model Money supply and inflation have opposite sign with our expectation but they are insignificant Interaction term is significant at 5% level All other thing being equal, one percentage point increase in inflation is associated with a decrease in GDP per capita growth 0.002 percentage point In this regression, I not find evidence for the view that IFI has a positive growth effect on real GDP per capita growth In this case, the result can be interpreted because two reasons Firstly, determinants of IFI that we used cannot not fully distinguish differences in barriers to international financial transactions The second, data in research not consistent to the view that IFI will promote economic growth Although interaction term strongly significant at 2% with negative sign We find weak evidence that inflation affect the benefit of international financial integration on economic growth because coefficient of this variable is quite small All other thing being equal, one percentage point increase in inflation is associated with a decrease growth effect of IFI 0.002 percentage point Moreover, we have interesting finding that the result is robust when we using flow data for IFI variable It states that FDI flow may be more appropriate to address response of market from changes due to IFI process such as policy change, capital allocation, especially when the world witness many fluctuations in research time However, stock data have lower noise than flow data Hence, flow data may be more suitable limit in data of this research Ho Thy Dung / MDE K21 36 Chapter CONCLUSION AND POLICY RECOMMENDATIONS 5.1 Conclusion Together with the growing trend of international financial integration and cross border investment in recent year, my paper aims to investigate the contribution of IFI on economic growth and to assess the IFI-growth relationship under specific conditions of the countries in the period 1982-2014 Using the new data and GMM panel regression, I provide the most up-to-date picture about the effects of IFI on GDP In empirical analysis, my research find a positive significant relation between international financial integration and economic growth when using FDI flows to represent to IFI My findings are consistent with theory literature that increasing in capital will increase the economic growth When the total of stock of FDI and portfolio investment is used as the measure of IFI, we have insignificant result The sign is consistent with our expectation And we also find a weak evidence that IFI process with low inflation rate tend to take greater growth effect It is consistent with theory background Interestingly, we find a relation between money supply and economic growth in model (with IFI1 represent IFI) It is contrast with belief that financial system will benefit to growth I believe that the result is influenced by financial crisis in research time because countries with more developed financial systems will be more affected by the crisis 5.2 Policy Implications The findings may not completely significant implication for policymaker However, it indicated the important role of IFI and can be used as reference We suggest that government should have better policies to encourage international financial integration Secondly, the study point out that Government need to control inflation rate of domestic economy On the other side, the impact of IFI vary across different measures of IFI In theory, IFI should facilitate the economic growth However, this process has benefits as well as costs The benefits of IFI can be offset by the increase of vulnerable ability Ho Thy Dung / MDE K21 37 to financial fluctuations in the world The mix results in relation of IFI and economic growth is a warning sign for policymakers They need to consider negative impact of international capital flows and have suitable policies to appraise international projects Moreover, they should have policies to channel flows into sectors that will boost economic growth 5.3 Limitation and further research Firstly, with limitation of time and data, my research only focus on de factor variables that I can have best data It means that the results for other variables may different Secondly, in reality, the hypothesis whether the effects of IFI on economic growth relies heavily upon external conditions such as economic recession, global financial crisis, etc By adding an interactive term, we could examine this hypothesis However, it is getting more complicated with recent research Hence, we let this problem to be resolved by other researchers Ho Thy Dung / MDE K21 38 REFERENCE ABBES, S M., MOSTÉFA, B., SEGHIR, G & 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Ho Thy Dung / MDE K21 40 APPENDIX: List of 48 countries in research 10 11 12 13 14 15 16 Argentina Australia Benin Bangladesh Bahrain Belize Brazil Barbados Botswana Canada Switzerland Chile China Cameroon Colombia Costa Rica 48 Countries in Data Sample 17 Cyprus 33 18 Denmark 34 19 Egypt 35 20 United Kingdom 36 21 Grenada 37 22 Guatemala 38 23 Honduras 39 24 Iceland 40 25 Israel 41 26 Korea 42 27 Kuwait 43 28 Mexico 44 29 Malaysia 45 30 Namibia 46 31 Nigeria 47 32 Norway 48 Pakistan Peru Philippines Saudi Arabia Singapore Sweden Swaziland Seychelles Thailand Tunisia Turkey Uruguay United States Venezuela Viet Nam South Africa Regression Result from Panel Data Result with IFI1 and all control variables Ho Thy Dung / MDE K21 41 Result with IFI1, adding and subtracting variables Ho Thy Dung / MDE K21 42 Ho Thy Dung / MDE K21 43 Result with IFI2 and all control variables Result with IFI2, adding and subtracting variables Ho Thy Dung / MDE K21 44 Ho Thy Dung / MDE K21 45 Ho Thy Dung / MDE K21 46 Fisher test for independent variables Ho Thy Dung / MDE K21 47 Ho Thy Dung / MDE K21 48 Ho Thy Dung / MDE K21 49 ... Weak positive link from financial integration to the development of domestic financial system but no evidence of effect of IFI on growth No robust evidences on the growth benefit of IFI even A weak... methodology of the IFI, a large number of the researchers in the last few centuries focused explore the impact of the IFI to the developing countries (DCs) Although theoretical basic of growth benefit of. .. Since the late 1980s, the world has witnessed a trend towards the deepening integration of the domestic financial markets There are many research on growth benefit of international financial integration