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Connecting Two Views on Financial Globalization: Can We Make Further Progress? Shang-Jin Wei IMF, NBER & CEPR Personal Views Only • What does Financial Globalization do? • The gap between theories and empirics – In theory, benefits through many channels • Direct: savings, cost of capital, and transfer of technology, • Indirect: development of domestic financial market, more specialization, and better policies – In the data, evidence not strong (Eichengreen, 2000; Prasad, Rogoff, Wei, and Kose, 2003; Kose, Prasad, Rogoff, and Wei, 2006) • Reconciling theories with empirical patterns: • Two independent proposals – The composition effect: • Some capital flows are more beneficial than others – The threshold effect: • Benefits of FG can be realized only if the recipient countries meet some conditions • Eichengreen (2000), Prasad, Rogoff, Wei, and Kose (2003) Roadmap for discussion • How do the two effects work? • My take on the two effects – The composition is a reflection of the threshold effect • Challenges to this interpretation • Response to the challenge The composition hypothesis • Not all capital flows are equal • FDI and maybe portfolio inflow are more beneficial to growth than debt – Desoto and Reisen 2001; Bekaert, Harvey, and Lundblad, 2005, JFE • FDI is also less volatile than international bank loans -> More reliance on bank loans increases vulnerability to currency crashes – Frankel and Rose, 1996; Frankel and Wei, 2005 0 .02 .04 .06 .08 Volatility of (FDI/GDP) and (Loan/GDP) (1980-2003, Measured by Standard Deviation) . FDI/GDP Loan/GDP The Threshold Effect • Certain minimum conditions have to be met before a country can benefit from FG • Institutions – Low corruption / decent rule of law • Otherwise, FG may exacerbate distortions – Reasonable level of financial development • So international capital can be channeled into investment – Human capital Are the Two Effects Connected? • Yes! – Earlier: Wei (2000, 2001), Wei and Wu (2002) – Recently: Faria and Mauro (2005) • Why? – Insight from the literature from corporate finance – A built-in bias in the international financial architecture Challenges • Countries with worse financial institutions appear to attract more (not less) FDI • Albuquerque (JIE 2003) • Also see Hausmann and Fernandez-Aris (2000) • Even if public governance and composition of capital inflows are related as hypothesized, how do we know the relationship is causal? Answers to the Challenges • Separate the effects of financial development and weak governance • Find instrumental variables for government corruption and financial development Why would weaker financial development be associated with more FDIs? • Caballero, Farhi and Gourinchas, 2005, “An eqbm model of ‘global imbalances’ and low interest rates.” • Ju and Wei, 2005, “A solution to two paradoxes on international capital flows” • Instrumental variable for government corruption: • Initial cost to colonizers –mortality rate of European settlers before 1850 • Acemoglu, Johnson, and Robinson (AER 2001) • Alternative: initial population density in 1500 • Instrumental variables for financial development: • Legal origins: La Porta, Lopez-de-silanes, Shleifer, and Vishny (JPE 1998) • Settler mortality (History-based) instrumental variables • Corruption is mostly affected by settler mortality but not by legal origin • Financial development is affected by both legal origins and settler mortality. • The basic specification: (1) Composition(j) = β1 Corruption(j) + β2 FinDev(j) + Z(j)Γ + e(j) Zj is a vector of control variables, β1, β2, and Γ are parameters ej is a random error. First Stage Regressions: Using Histories to Instrument Modern-day Institutions (1) Log(settler mortality) Corruption(GCR/WDR) (2) (3) (4) Financial development (5) (6) (7) Institutional Quality (8) (9) 0.46** 0.31** -0.21** -0.38** -0.29** (0.08) (0.08) (0.03) (0.07) (0.07) Log(Population density in 1500) 0.27** (0.07) 0.10 (0.08) -0.07** (0.03) Legal origin (French) 0.37 (0.23) 0.62** (0.22) -0.18** (0.08) -0.14* (0.08) -0.18** (0.08) -0.06 (0.17) Legal origin (German) 0.00 (0.00) 0.00 (0.00) 0.74* (0.38) 0.00 (0.00) 0.00 (0.00) 0.00 (0.00) Legal origin (Scandivanian) 0.00 (0.00) 0.00 (0.00) 0.70* (0.38) 0.00 (0.00) 0.00 (0.00) 0.00 (0.00) Legal origin (Socialist) 0.71 (0.66) 0.79 (0.72) -0.25** (0.10) -0.29 (0.21) -0.14 (0.25) -0.98** (0.45) 40 0.36 44 0.20 120 0.14 60 0.47 73 0.14 Observations R-squared 44 0.44 48 0.24 70 0.33 61 0.29 Explaining the Ratio of FDI/ Total Foreign Liabilities in 2003 Corruption(GCR/WDR) -0.10** (0.04) Financial development IV regressions -0.65** (0.23) 0.17* (0.09) -1.07** (0.44) -0.56** (0.24) -0.88* (0.46) Resource a 0.13 (0.13) Openness a 0.12* (0.07) Observations R-squared 40 0.15 34 0.09 34 0.28 34 0.36 Explaining Portfolio Equity/Total Foreign Liabilities in 2003 Corruption(GCR/WDR) -0.07** (0.01) Financial development IV regressions 0.06 (0.09) 0.14** (0.03) 0.25 (0.17) 0.09 (0.09) 0.31* (0.18) Resource a 0.04 (0.05) Openness a 0.01 (0.03) 34 0.40 Observations R-squared 40 0.37 34 0.37 34 0.38 Explaining Portfolio Debt/ Total Foreign Liabilities in 2003 Corruption(GCR/WDR) -0.10** (0.03) Financial development IV regressions -0.34** (0.14) 0.19** (0.05) -0.45* (0.26) -0.31** (0.14) -0.40 (0.27) Resource a 0.05 (0.08) Openness a -0.08* (0.04) Observations R-squared 40 0.26 34 0.27 34 0.39 34 0.47 Explaining Outstanding Foreign Loans/ Total Foreign Liabilities in 2003 Corruption(GCR/WDR) 0.36** (0.06) Financial development IV regressions 0.87** (0.30) -0.57** (0.13) 1.10* (0.60) 0.67* (0.33) 0.65 (0.66) Resource a -0.15 (0.18) Openness a -0.23 (0.14) Observations R-squared 38 0.53 33 0.38 33 0.52 33 0.56 Total Capital Inflows Per Capita in Logarithm (2003) Corruption(GCR/WDR) IV regression -6.48** 0.79 (1.56) (1.69) -2.15** (0.36) Financial development 2.57** (0.71) -9.74** (3.01) 0.88 (1.79) 0.68 (2.80) 0.87 (3.00) Log(Human capital stock) 0.32 (0.38) 0.31 (0.40) Log(Capital stock per capita) 0.95** (0.18) 0.92** (0.19) Resource a 0.33 (0.74) Openness a 0.22 (0.39) Observations R-squared 40 0.48 34 0.29 34 0.54 28 0.82 28 0.82 Table 6: Alternative Measure of Institutions – Average of Six World Bank Indicators FDI/total foreign liability IV Regression Portolio equity Portolio debt /total foreign /total foreign liability liability Loan/total foreign liability Institutional Quality 0.67** (0.29) -0.11 (0.11) 0.38** (0.17) -0.81* (0.40) Financial development -0.88* 0.31* -0.40 0.65 (0.46) (0.18) (0.27) (0.66) Resource a 0.13 (0.13) 0.04 (0.05) 0.05 (0.08) -0.15 (0.18) Openness a 0.12* (0.07) 0.01 (0.03) -0.08* (0.04) -0.23 (0.14) Observations R-squared 34 0.36 34 0.40 34 0.47 33 0.56 Table 7: Adding more control variables (IV Regressions) FDI/total foreign liability (1) -0.55** (0.24) (2) -0.42* (0.25) Portolio equity/total foreign liability (3) (4) 0.09 0.17* (0.10) (0.09) Financial development -0.87* (0.48) -0.76 (0.46) 0.31* (0.19) 0.38** (0.16) -0.48* (0.26) -0.42* (0.25) 0.72 (0.68) 0.28 (0.54) Resource a 0.13 (0.13) 0.12 (0.13) 0.04 (0.05) 0.04 (0.04) 0.05 (0.07) 0.05 (0.07) -0.15 (0.18) -0.16 (0.14) Openness a 0.13* (0.07) 0.17** (0.07) 0.01 (0.03) 0.04 (0.02) -0.09** (0.04) -0.07* (0.04) -0.22 (0.15) -0.39** (0.12) FDI restrition Dummy -0.01 (0.05) -0.06 (0.06) -0.00 (0.02) -0.03* (0.02) 0.05* (0.03) 0.02 (0.03) -0.04 (0.07) 0.09 (0.06) 34 0.36 0.04* (0.02) 34 0.43 34 0.40 0.03** (0.01) 34 0.58 34 0.53 0.02* (0.01) 34 0.59 33 0.57 -0.10** (0.02) 33 0.74 Corruption(GCR/WDR) Log(GDP) Observations R-squared Portolio debt /total foreign liability (5) (6) -0.34** -0.27* (0.14) (0.13) Loan/total foreign liability (7) 0.69* (0.34) (8) 0.29 (0.28) Summary (1) • Corruption does not appear to have a strong effect on a country’s total foreign liabilities. • It affects the composition significantly. As FDI and portfolio debt are strongly discouraged, foreign loans take their places. • Corruption increases a country’s vulnerability to a balance-of-payments crisis by altering its composition of capital inflows in an unfavorable direction. Summary (2) • Financial development does not appear to have a strong effect on total foreign liabilities. • However, a weaker financial system appears to induce more FDIs. • A weaker financial system is likely to discourage inflows of portfolio equity and portfolio debt.