UNIVERSITY OF CAMBRIDGE Centre for Economic and Public Policy
How and Where Capital Account Liberalization Leads to Economic Growth Dennis P Quinn Professor McDonough School of Business Georgetown University Washington, D.C 20057 quinnd@gunet.georgetown.edu Carla Inclan Ernst & Young, LLP Washington, D.C 20036 carla.inclan@ey.com A Maria Toyoda Research Scholar Institute for International Studies Stanford University Stanford, California atoyoda@leland.stanford.edu © by the American Political Science Association Prepared for Presentation at the 2001 Annual APSA Convention, San Francisco, California We thank the Georgetown University McDonough School of Business and the National Science Foundation for their support (SBR9810410) Please direct comments to Dennis Quinn (30 August 2001) ABSTRACT We utilize an empirical model of growth as a platform for examining the effects of capital account liberalization on growth While we test for the direct effects of liberalization, we are equally interested in another facet of liberalization: sequencing We ask what prior political, social, or economic conditions were required for capital account liberalization to have led to subsequent growth Our key independent variable is a measure of capital account openness that comes in the form of five-year time-series, cross-sectional observations for 80 nations, 1950 (or independence) to 1997 Our focus is on change indicators of liberalization, as we argue that level indicators of government policies in political economic research are generally too imprecisely specified to exclude the influence of other collinear political economic variables We focus not simply on the economic preconditions for beneficial liberalizations, but the political and social preconditions as well We find that capital account liberalization has a robust and direct effect on subsequent economic growth in most countries Capital account liberalization does not, however, lead to higher growth in emerging market democracies that have weak welfare states We conclude that policymakers in emerging market democracies have ample reason to be cautious about full capital account liberalization Policymakers in emerging market nations are routinely urged to liberalize their international economic transactions Scholars, journalists, and experts from international development agencies laud the growth and development benefits of freer trade in goods and services in particular (See Rodrik 2000 for a critical review of this advice.) Is this advice sound regarding international capital flows? That is, if a government of an emerging market nation were to liberalize its restrictions on inward and outward capital flows, what would be the growth effects in the liberalizing economy? We offer a partial answer to these questions in this paper We proceed as follows After a brief review of the relevant literature, we utilize an empirical model of growth as a platform for examining the effects of capital account liberalization on growth While we test for the direct effects of liberalization, we are equally interested in another facet of liberalization: sequencing What prior political, social, or economic conditions were required for capital account liberalization to have led to subsequent growth? Our paper makes several contributions We introduce a measure of capital account openness that comes in the form of five-year time-series, cross-sectional observations for 80 nations, 1950 (or independence) to 1997 We focus on change indicators of liberalization, arguing that level indicators of government policies in political economic research are generally too imprecisely specified to exclude the influence of other collinear political economic variables We focus not simply on the economic preconditions for beneficial liberalizations, but the political and social preconditions as well We have new results, which we discuss at the end of the paper I A Brief Review of the Capital Account Liberalization and Growth Literature The starting point of this paper on the growth effects of capital account liberalization is the recent and comprehensive review essay on the topic by Barry Eichengreen (forthcoming) Eichengreen notes that various theoretical models drawn from economics imply inconsistent effects from capital account liberalization One strand of literature, drawing on traditional “frictionless” factor market models, proposes that capital account liberalization produces growth effects for many of the reasons trade liberalization does (See also Sweeney 1997.) A second strand of theory, however, proposes that many types of policy-based distortions in a nation’s economy lead to suboptimal outcomes from capital account liberalization as the distortions create “second-best” conditions (See Stiglitz 2000, e.g.) To a very large extent, the differences in the two perspectives derive from different starting assumptions about the policy and economic environments under which liberalization occurs Given the conflicting starting assumptions and resulting theory, we might reasonably hope that empirical studies of the many countries that have liberalized their capital accounts might narrow the theoretical discourse Unfortunately, the first round of “large n” empirical studies of the direct effects of capital account liberalization produced indecisive results Grilli and Milesi-Ferretti 1995 found no association between the levels of capital account openness (hereafter Openness) and economic growth, a finding that Rodrik 1998 replicated and extended Quinn 1997 showed that changes in capital account openness (hereafter Liberalization) were associated with higher long-run growth Focusing on emerging markets, Bekaert, Harvey, and Lundblad 2000 also find that incidences of financial liberalizations were associated with subsequent economic growth Much of the difference is in the data used Grilli and Milesi-Ferretti and Rodrik use a binary 0,1 indicator of the presence or absence of capital controls found in a table at the back of the International Monetary Fund’s annual publication, Exchange Arrangements and Exchange Restrictions The IMF 0,1 data contains too little information for it to be used to study Liberalization per se, but only levels of Openness The Quinn study is based on a coding of the text of the laws governments used to regulate capital accounts, which are reported in the text section of Exchange Arrangements (The Quinn/Toyoda measure is described below.) These data contain ample information to generate a study of Liberalization, but the range of countries and years for which data were available was limited The Bekaert, Harvey, and Lundblad 2000 study also used a 0,1 measure, but this measure, unlike the IMF’s, is linked to the date of the liberalization Eichengreen forthcoming reviews the data and methodological differences among most of these and other studies (For discussions of the different data measures, see also Edwards 2001 and Quinn 1997.) A second round of studies moves beyond the direct effects of Openness on growth to a focus on the channels through which openness might produce growth Kraay 1998 finds scant evidence of the effects of Openness on investment Klein and Olivei 1999 show Openness leads to financial “deepening,” but only for advanced industrial nations Klein and Olivei propose that emerging market nations lack some key political economic institutions through which Openness might act beneficially, which implies that Openness has a contingent relationship to growth Klein and Olivei use a summed version of the 0,1 IMF indicator for 1986-95 Levine and his coauthors, in a series of papers (King and Levine 1993; Levine and Zervos 1998; Beck, Levine, and Loayza 2000), find that financial or stock market development leads to growth, though whether Openness or Liberalization contributes to that process was not addressed in those papers Scholars undertaking a third round of studies test a version of the proposition that Openness or Liberalization’s effects are contingent upon various economic and policy preconditions Diaz-Alejandro 1985 notes that financial liberalization in emerging market nations often produced poor results, leading to the question of what prior states distinguished emerging market nations from other nations Kraay 1998 finds little evidence that Openness’ effects are contingent on various economic preconditions Edwards 2001 finds that Liberalization lead to growth in middle to high-income countries Arteta, Eichengreen, and Wyplosz 2001 revisit Edwards’s study, and while they reject his findings on methodological and other grounds, they suggest that Liberalization does indeed have a contingent relationship with growth The contingency that matters, they believe, is macroeconomic imbalances – as exemplified by black market premia Chandra 2001, investigating sociological contingencies, finds that countries with higher levels of ethnic heterogeneity were actually harmed by Openness More homogenous societies, in contrast, benefited Edwards and Arteta et al used the same indicator as Quinn 1997, whereas Chandra used the IMF 0,1 data These studies have advanced our understanding of capital account openness and its effects The search for contingencies under which liberalization produces beneficial effects is a particularly promising avenue of research Even so, the prior studies have some limitations For one, the 0,1 measure of capital account openness taken from the IMF tables is of limited further use Another lesson we can take from the prior studies is that purely cross-sectional research designs are unlikely to reconcile some of the differences among the studies because of the necessarily limited range of information that can be entered as independent variables in purely cross-sectional models Perhaps the salient problem found in the prior studies is a central problem of empirical political economic scholarship generally – nations at similar levels of political, social, and economic development have similar “clusters” of political economic policies and structures Of relevance to this study, the levels of Openness are, without question, part of a broader cluster of policies and processes, and are therefore collinear with many other variables (We will develop this point below as we describe the “repression syndrome” and the “liberalization cycle.”) For related discussions, see Arteta, Eichengreen, and Wyplosz 2001, 11; Rodríguez and Rodrik 2000, 28-34; and Eichengreen forthcoming, We explicitly address the first and third round of studies of capital account liberalization and growth We use annual indicators of capital account restrictions for 77 countries to construct five-year panel averages, 1960-98 based on the same data and coding rules as Quinn 1997 The range of information allows us to compute meaningful indicators of change in capital account regulation, and it also allows us to enter a wide array of information into the analysis We also use a robust method pooled-cross-section, time-series analysis To guard against simultaneity, we use long lags of the key independent variables We overcome in part the policy cluster problem by focusing on changes in capital account regulation, while including levels (Openness), along with many other variables as control variables in a pooled regression model Both levels and changes in capital account regulation carry relevant information, but in a time-series, cross-section research design, changes in Openness are less likely to exhibit collinearity with other “cluster” variables A further advantage of focusing on Liberalization rather than Openness is that Liberalization is a topic of greater policy relevance for many emerging market nations II The Repression Syndrome and the Liberalization Cycle Groups of countries have hard-to-measure, common attributes for many reasons Nations share strategic interests, citizens of nations at similar levels of development have similar tastes, and many nations share common linkages from emigration and colonization Other groups of nations, even with otherwise different cultures and traditions, have shared ideological or religious beliefs Of importance to this investigation is that these common experiences and values lead nations to adopt similar – and related – political economic policies Let us develop a relevant example If the political elite of a group of nations were to share a belief in the efficacy of markets, we might see these countries adopt similar institutions and policies A floating exchange rate, open trade accounts, an independent central bank, anti-inflationary policies, and open capital accounts might jointly characterize these economies As policies are hard to measure precisely, the effects of mutually related policies are sometimes conflated For example, capital account openness might proxy for the above list of related policies across countries Moreover, even if economic policies could be measured precisely, because these economic policies are frequently collinear, the econometric difficulty of estimating the effects of any one policy is great Regarding international financial liberalization, we find two distinct types of political economic clusters (This section draws on Quinn 2000.) Low levels of capital account openness are associated with lower levels of per capita income, lower levels of trade openness, weaker financial development, higher levels of inflation, fixed exchange rates, and higher premia on the black market for foreign currencies These are characteristics of what McKinnon 1973 called a financially repressed economy These economically repressed countries are frequently also politically repressed (Quinn 2000), and highly vulnerable to political instability Politically repressed economies are characterized also by low rates of investment in human capital (Helliwell 1994) and high birthrates (Feng, Kugler, and Zack 2000) These joint and cumulative attributes of political and economic repression we will henceforth call the “repression syndrome” of which capital account closure is only one part In an econometric crosssectional investigation, one of the indicators of the repression syndrome is highly likely to capture part of the influence of the other indicators Let us turn to a “liberalization cycle.” From the 1950s onward, most democratic governments have liberalized finance and liberalized trade (Quinn 2000) These economically open countries developed strong financial sectors, produced low levels of inflation (comparatively speaking), and had very limited black markets in currencies These democracies also invested in human capital and had lower birthrates than similar countries, and per capita income was higher than in authoritarian countries Democratic countries were far less vulnerable to revolutions, coups, and other forms of political instability than other nations, in part because democratic nations followed economic policies that decreased economic risk even at the expense, at times, of higher growth (Quinn and Woolley 2001) These generalizations apply at least partially to both emerging market as well as advanced industrial democracies We present some evidence on the repression syndrome and the liberalization cycle in Tables and where we report the simple correlations between variables, 1960-98 (using five year averaged data, which will be described below) [Tables and about here] The pairwise contemporaneous correlations not capture change over time, not take into account the effect of other variables, and tell is little about the direction of relationships But, they help us make the point that political economic variables are correlated in line with the repression syndrome and the liberalization cycle Note that the repression syndrome and liberalization cycles also present themselves, albeit in a weaker form, in the emerging market data An empirical implication for our project is that political economic clustering exposes to challenge estimating the direct effects of Openness We will show below that the levels of capital account openness, lagged two periods, usually have a statistically significant and positive coefficient when entered in a growth regression But, because of the clustering of variables, we cannot directly tell whether the levels of Openness, or some other aspects of the repression syndrome or the liberalization cycle, are what is actually linked to subsequent growth In the second part of our analysis, we make use of the information found in these and other political economic variables to examine whether Liberalization has a direct or contingent (or both) relationship to economic growth We turn now to a discussion of the possible contingencies III Preconditions for the Benefits of Liberalization? The Liberalization cycle and the repression syndrome are not simply econometric problems More importantly, these political economic states potentially reinforce, enable, or impede other policies Are features of the liberalization cycle necessary preconditions for capital account liberalization to generate growth? Do features of the repression syndrome impede the positive effects of capital account liberalization? Economic States as Preconditions for Liberalization This section draws on the prior work of Edwards 2001 and Arteta, Eichengreen, and Wyplosz 2001 The authors of these papers see Liberalization as having a contingent, rather than direct, effect on growth The core conclusion of the Edwards 2001 study is that economic development, proxied by per capital income, was a precondition for the benefits of Liberalization The Arteta, Eichengreen, and Wyplosz 2001 paper examines a number of policy preconditions for the benefits of Liberalization to occur They use indicators of trade liberalization from Sachs and Warner 1995 and the premiums paid in black markets for foreign currencies as indicators of imbalanced macroeconomic conditions They advance the theory that the benefits from Liberalization are likely to occur only after key distortions have been eliminated to prevent either misdirection of the resulting inflows or capital flight Two additional questions then emerge about related policies… The first is whether the prior liberalization of international financial transactions associated with the underlying current account transactions might produce benefits different from liberalizing the underlying transactions themselves The second is whether financial development is a precondition for the positive effects of capital account liberalization Arteta, Eichengreen and Wyplosz 2001 not find such an effect, but we test for it Political and Legal States as Precondition for Liberalization We draw on Quinn 2000 and Quinn and Woolley 2001 for this section Wealthy democracies have been relentless liberalizers of both capital and current accounts See Figure 1, which shows median levels of Openness over time for three groups of countries: democratic OECD nations, continuously democratic emerging market nations,1 and We define continuously democratic emerging market nations as those whose summed democracy/autocracy Polity 98 scores were continuously above on the –10 to 10 scale, 1960 (or after independence) to 1995 These nations are Botswana, Colombia, Costa Rica, India, Israel, Jamaica, and Trinidad If we were to stretch the definition of democracy to include nations whose Polity 98 scores are continuously above zero, we would include Malaysia, South Africa, Sri Lanka, and Venezuela continuously autocratic nations,2 1950-97 Emerging market democracies, while generally more open than authoritarian emerging market nations, were characterized by far lower levels of Openness than OECD democracies The lower levels of Openness might be explained in part by a finding in Quinn 2000, which was that capital account liberalization was a risk factor contributing to democratic reversals in emerging market democracies Capital account liberalization is robustly associated with subsequent increased income inequality (Quinn 1997) Dixon and Boswell 1996 find that foreign investment “penetration,” which follows from capital account liberalization, also increases income inequality (cf Firebaugh 1996) Increased income inequality, in turn, has deleterious effects on polities, particularly emerging market polities (Muller and Seligson 1987) Democracies, therefore, tend to compensate losers from market competition These “sidepayments” take the form, in wealthier democracies, of direct transfer payments In poorer democracies, however, the ability to make direct transfer payments is limited by their ability to tax and fund a welfare system Consequently, emerging market democracies use other mechanisms of compensation, such as employment in state-owned enterprises or trade protection Even private firms in emerging market democracies frequently provide social welfare benefits to society (Khanna 2000) Capital account liberalization, however, constrains the ability of these democratic countries to maintain these other forms of compensation We might therefore expect that the transactional costs of dismantling traditional methods of compensation and establishing new ones are very high Non-democratic nations presumably are less concerned with compensation Hence, the growth benefits of Liberalization might be less for emerging market democracies than other nations A second possible explanation for lower levels of Openness in emerging market democracies is that voters in all forms of democracy are characterized by a high degree of risk aversion Quinn and We define continuously autocratic nations as those whose summed democracy/autocracy Polity 98 scores are continuously zero or below, 1960 (or shortly after independence) to 1995 These nations are Algeria, Bahrain, China (PRC), Egypt, Ethiopia, Indonesia, Iran, Iraq, Jordan, Kenya, Morocco, Rwanda, Syria, and Tunisia Appendix B Partial Residual Plots A partial residual plot shows the relationship between Y and Xi controlling for all other explanatory variables in the model To obtain a partial residual plot we follow these steps: a) Estimate a model Y = f(X1,…, Xi-1, Xi+1, Xk) and obtain residuals: res(Y | X) b) Estimate other model Xi = f(X1,…, Xi-1, Xi+1, Xk) and obtain residuals: res(Xi | X) c) Plot res(Y | X) against res(Xi | X), the slope of the line in that plot corresponds to the coefficient of Xi in the multiple regression Y = f(X1,…, Xk) d) To confirm the above statement we estimate a third model: res(Y | X) = f( res(Xi | X) ) and present that coefficient in the title of the partial residual plot To explore the possibility that the relationship between growth and Change in Capital Account Openness is different for different groups of countries, we obtained partial residual plots and display them separately for four groups obtained from the combination of two variables: fully democratic and OECD Forty-one countries are not fully democratic/non-oecdi; seven are fully democratic/nonOECD; four are not fully democratic/OECD; and 18 are democratic/OECD The four plots on each page correspond to one of the explanatory variables in the base model (with pwt 6.0) The solid line is the line obtained with all the residuals as indicated in ( c ) above The dashed line is obtained with the subset of points shown in each plot The title indicates which group is presented in each of the four plots The coefficient estimates for the effects of Change in Capital Account Openness (DCAP5) on economic growth for each group of countries are reprinted below (Appendix Figure 1.) Transitional Polities Autocratic Polities Emerging Market Dems OECD Democracies coef std.err t.stat p.value 0.0262 0.0103 2.54 0.0117 0.0263 0.0297 0.89 0.378 -0.0447 0.0289 -1.5469 0.1289 0.0345 0.0118 2.916 0.0041 number of countries 34 11 18 The coefficient estimates for the effects of Capital Account Openness (DCAP5) on economic growth for each group of countries are reprinted below (Appendix Figure 2.) Transitional Polities Autocratic Polities Emerging Market Dems OECD Democracies coef std.err t.stat 0.052 0.0122 4.26 0.0421 0.0314 1.34 -0.0545 0.0392 -1.39 0.0393 0.0114 3.45 p.value