Download Reserve Uncertainty and the Supply of International Credit

Endogenous Financial and Trade
Openness: Efficiency and Political
Economy Considerations
NBER working papers #10144, 10496
Joshua Aizenman
University of California
Santa Cruz
Ilan Noy
University of Hawaii
Manoa
1
The Purpose
 Studying
the endogenous determination of
financial openness
 Two benchmark models of financial openness:


Public finance, representative agent
Opportunistic policymaker, facing political uncertainty
 Empirical


work
Decomposing the linkages between financial and trade
openness
Identifying the determinants of financial openness
2
Higher trade openness reduces optimal financial repression
TRADE OPENNESS
(t)…(t+2)
FINANCIAL
OPENNESS (t+1)
Higher vertical FDI increases international trade,
cheaper trade credits, etc.
3
De-facto Financial Openness
Most studies focused on the formal acts
associated with de-jure financial opening.
De-facto financial integration is of
independent and considerable interest.

Prasad et. al. (2003), Wei and Wu (2003)
The de-facto level of financial openness is the
outcome of the interaction between:
de-jure financial openness
 enforcement
 market forces

4
The public finance model
 The

policy maker problem:
how to fund given G relying on income tax and on
financial repression.
 Costly
taxes:
income tax is associated with collection costs;
 financial repression is associated with expenditure
on monitoring and policing.

 The

consumer’s problem:
capital flight (with risk of appropriation) or
domestic bonds (income taxed).
5
Results: The
public finance model
 Financial
repression is optimal below a
threshold of fiscal efficiency
 Higher cost of tax collection, higher fiscal
expenditure and lower commercial openness
would increase the “optimal” financial
repression.
 Cukierman, et al. (1992):
functioning democracies and less polarized societies tend
to have more efficient tax collection systems, hence tend
to be associated with lower taxes and lower capital
flight.
6
The opportunistic model
 The
policy maker controls the income from
exporting a natural resource, and faces an
uncertain future horizon.
 Second period output is determined by first
period investment (financed by the policy
maker, or by outside parties).
 The policy maker chooses between investing
(and producing output in the second period)
or moving the income offshore (where it will
be consumed by the policymaker).
7
Results: The
 Higher
opportunistic model
probability of regime change 
First-period policy maker increases offshore
saving and reduces investment.
 increases the investment financed by the outside
party.

 Higher
probability of regime change would
increase both capital flight and capital inflow
 higher de-facto financial openness.
8
Empirical methodology

Determinants of financial openness:
FOit    1 X it  2 COit1  3Pit   it
 it   it 1   it




1.

Macro controls: vector X
Average lagged commercial openness – COit1
Political economy controls: vector P
Estimation using the Prais-Winsten procedure:
A two-step FGLS using the estimated correlation coefficient
obtained from a first-step OLS regression (from the DW statistic).
Reverse specification for trade openness
 Decomposition of causality
9
Financial Openness
(percent of GDP)
20
15
10
5
0
1970s
East Asia
1980s
Latin America
1990s
Others
OECD
1
0
Overview of results: Empirics
 De-facto
I
financial openness (FO) depends…
positively on lagged trade openness and
GDP/Capita.
 negatively on the budget surplus for developing
countries (positive for the OECD).
 negatively on corruption.
 A more openly competitive, democratic, free,
and inclusive political system is associated with
lower FO .

(The effect is more significant once we control for corruption).
1
1
Overview of results: Empirics
II
 For
developing countries, a one s.d. increase
in…
commercial openness increases FO By 9.5%,
 the democracy index reduces FO by 3.5%,
 corruption index reduces FO by 3%.

 Reverse
causality from financial to trade
openness is also quantitatively important.
 Decomposition of links between financial and
trade openness (Geweke decomposition)
1
2
For future research
 Disaggregate de-facto
financial openness,
and de-facto trade openness into their
various components.
 A more direct empirical investigation into
some of our hypotheses is called for:
direct measures of tax collection efficiency (for
different tax instruments).
 a more direct measure (or a better proxy) for
political uncertainty.

 Bi-lateral
data-set for financial flows
1
3