Download Financial Development and Capital Account Openness. What Links between Them?

Financial Development and Capital Account Openness.
What Links between Them?
HUANG Dan, HUANG Xian
Economics and management School, Wuhan University, P.R.China 430072
[email protected]
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Abstract: In this paper, we analyze the mutual impacts of the efficiency of financial system and the
effects of capital account openness, and introduce the theory evolution of their correlation, thus to
highlight the importance of arranging the reform sequence of the capital account openness and the
development of financial system so as to reap the benefits of the liberalization. Meanwhile, we state that
both the policies of capital and the economic operation mechanism will change post the capital account
openness. Hence, the key points to assure the reform success is to make the reform polices coordinate
with each other, match them with the economy operation mechanism. At the same time, these reform
polices need to be performed in a dynamic way as well..
Keywords: Capital account openness, financial intermediary, financial market, financial development
1. Introduction
The reform of capital account openness is pivotal to every country. At best, the free mobility of
international capital will lead to a capital inflow that stimulates investment and facilitates economic
growth. At worst, the capital flight and the sudden reversal of capital inflow will cause financial
instability and even financial crises. Among those factors affecting the effect of capital account openness,
recent studies increasingly strengthen the important role of the efficiency of financial system. On one
hand, it is extensively thought that further reforming financial sector and prompting the efficiency of
financial system are prerequisite for capital account openness. On the other hand, the frequent financial
crises following the capital account openness seem to demonstrate something different. In this paper, we
are intended to explore what the interaction is between the efficiency of financial system and the effects
of capital account openness, meanwhile to analyze the proper polices arrangement for those
development countries including China to gain most from the economy reform.
2 Impacts of financial development on the effects of capital account openness
Among the studies of the relationship between financial development and effects of capital account
openness, the prevailing view, expressed by McKinnon (1991) and Dornbusch (1998) is that success or
failure of capital account openness hinges on the efficiency of domestic financial institutions. If
financial intermediaries induce capital to high productive sector, then it is efficient and the country will
benefit; otherwise, the counties will suffer financial crises. With this in mind, Fischer (1998) and Calve
(1998) have also documented that if financial intermediates can alleviate information asymmetry issues
such as moral hazard and adverse selection of domestic agents then any capital inflow will channel to
its most productive projects. Thus, reforming the financial sector should precede the capital account
openness. As for the linkage of financial market efficiency and the capital account openness, Durham
(2000a, b, c) has advocated that initial level of financial market is crucial, and economic growth is
positive with the development of financial market as well as the initial development level of domestic
credit rationing. Apart from above, the studies of Edwards 2001 and O’Donnell 2001 have revealed
that a country can reap the benefits of capital account openness only if it has a mature financial market.
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Fund: Financial development and China’s income distribution: the theory, empirical analysis, and policies selection,
Sponsored by Ministry of Education of the People’s Republic of China (Fund Number: 06JA790116).
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Generalizing the latest studies, we may conclude the impact of financial system efficiency on the
effects of capital account openness as following.
Firstly, healthy and sound financial system is principal to prevent financial crises and ensure the
liberalization success. Under the background of capital account openness, the aggregate and the
structure of capital inflow depend on the development degree and stability of financial system. Healthier
the system is, more capital inflow will be. And the reform practice has revealed that after the capital
account openness, not only the reversal and speculative attack of huge hot money will cause the
instability of the financial system, but also the excessive capital inflow will increase inflation and real
exchange rate volatility, exacerbate the current account and currency fluctuation, and even make the
financial system more vulnerable. Meanwhile, in the process of liberalizing, the financial system has to
face external financial shocks directly. With an inefficient and weak financial system, once a crisis break
out, then a series of crises will follow. Moreover, a high efficiency and orderly operating financial
system is also the guarantee to protect from risks because of personal factors.
Secondly, capital account openness requires efficient financial system to supply infrastructure for
government to map out policies. After liberalizing capital account, it depends on the interest rate and
exchange rate to modulate capital flow, which means the financial markets, should be fairly depth for
the government to carry out monetary and exchange rate policies. We also need the financial market to
be depth and liquidity, so as to discover prices and diversify risks among market participants without
producing price fluctuation. Besides, if the domestic financial system is inefficient, then the inflow of
capital will result in excessive capital stock, which causes not only wasting but also crises when the
country can not repay their foreign loans.
Thirdly, the development level of financial system is decisive to the expropriation of foreign capital.
Generally, with a sound and robust banking system, a certain degree of credit expansion will be
beneficial to the economic growth even the credit expansion caused by capital inflow. Because not only
the banking itself will actively internalize the repaying pressure arouse by credit expanding, but also the
governmental authorities will force the banking to do so. While if the market failure exists in the
banking system, the huge capital inflow will stimulate domestic residents to invest and consume
excessively. Banks will also release the credit conditions and even use it to speculate on financing real
estate or providing loans to its employees or affiliations, thus involve the country in reckless lending and
systemic financial crises subsequently. Except that, Laura Alfaro et al. 2004 have argued that FDI plays
an important role in contributing to economic growth, while the level of development of local financial
markets is crucial for these positive effects to be realized. They found that the lack of development of
local financial markets will restrain an economy’s ability to take advantage of potential FDI benefits.
Whereas bad financial markets may mean that a country is not in a position to cope with unregulated
short-term capital flows. Therefore, FDI will accelerate economic growth in countries with well
functioning financial markets more than those with undeveloped financial system.
Finally, an energetic and developed financial system is necessary to compete with foreign banks.
Several mechanisms account for this. First, foreign bank entry will erode the franchise value of banking
license and reduce the profits of domestic banks. Next, foreign entry will bring Cream skimming.
Dominance in services and selling will spur foreign banks to explore Cherry-picking Strategy, namely to
select those projects and clients with potential profits and in good financial conditions, thus those
domestic banks have to confront with worse or riskier projects and clients. Last but not least, the erosion
of the franchise value and the loss of good clients will compel the domestic banks to confront with even
more intense competitions. So, if the financial system of a country is inefficient and insolvent, then it
may only cause the financial fragility and the loss of market share following the capital account
openness.
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3 Impact of the effects of capital account openness on financial development
3.1 The promotion of financial intermediaries’ efficiency
It is reasonable to expect that financial liberalization is intertwined with the financial development.
An empirical study of Bemirguc-Kent (1998) certifies that accompanied with the financial liberalization
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including capital account openness are always the decentralization and the entry of more foreign banks,
which will inevitably enhance the competition capability and the efficiency of domestic financial
institutions. Here, our analysis describes a number of plausible channels through which this effect could
have occurred. First, the prominent dominance of foreign banks in supplying financial products and
services will strengthen competition, which will therewith compel the domestic banks to improve their
managerial skills, introduce new processes and prompt competing capacity. Levine (1998) specifically
mentions that foreign banks may (I) improve the quality and availability of financial services in the
domestic financial market by increasing bank competition and enabling the application of more modern
banking skills and technology; (ii) serve to stimulate the development of the underlying banking
supervisory and legal framework and (iii) enhance a country's access to international capital. Second,
because foreign banks own advanced credit crisis rating and pricing system, liberalizing can prompt
credit rationing ability of domestic financial market. Amel et al. (2002) find that the inflow of capital
(FDI) may stimulate the financial development of a country by transferring superior managerial skills,
bank management systems and technology to the target banks of this country. Meanwhile, Hu Zu-liu
(2003) argues that the reason why England could maintain the core international financial center of
London lies in that liberalizing the capital account and financial market made England attract massive
European financial institutions into its country. As a result, many financial institutions inefficient or on
the edge of bankruptcy were annexed and purchased, leading to the whole financial system efficiency in
England enhanced.
The practices of last 25 years have witnessed this effect. Before capital account openness, financial
intermediaries in most developing countries are highly monopolistic, and the state-owned banks are
nearly in control of the whole financial system of a country. There are few other kinds of financial
institutions, other than the efficiency of these financial institutions. The situation has changed when
those countries liberalize their capital account. Not only the financial monopolistic degree has declined
in many countries, meanwhile, there come forth lots kinds of financial institutions, and the efficiency of
both these newly arisen institutions and those old ones had been improved. More over, an interesting
phenomenon is that, the decreasing degree of bank monopoly varies with the liberalization degree in
different countries. Those developed countries that success in liberalizing their capital account rather
thoroughly now has a lowest monopolistic degree, and the degree of those Asian countries that liberalize
relatively rapid also becomes very low, but the situation of bank monopoly still remains high in those
countries that liberalize laxly.
Meanwhile, capital account openness will also enhance the specialization of the financial services,
thus to make the financial system more efficient. Just as the same as the international trade, when its
financial system develops to a certain degree, a country can either gain economies of scale or control the
risk better by producing financial services and exporting them, but before this degree, it is optimal
economic benefit to import these financial services. Therefore, during the process of the capital account
openness, a country will find it more efficient and at lower cost to specialize in supplying and exporting
some financial services, while importing some other, than to supply all kinds of financial services by
itself. Meanwhile, a country can reap the benefits of scale economy and the benefits of international risk
sharing by concentrating on supplying some wholesale financial services. Therefore, liberalizing the
capital account, a country can motivate domestic financial sector to restructure and gain the competitive
advantages, as well as to involve itself in the international allocation so as to enhance its efficiency in
supplying financial services.
3.2 The promotion of financial market’s efficiency
As for the financial market, if it is efficient, it should react only to new information. The efficient
market hypothesis postulates that as markets become more open and transparent to the public, the prices
of assets should reflect the greater availability of information and be more efficiently valued. In other
words, as home and global investors have a greater access to the domestic market, the current price of
the asset should come to embody all available, public and private, information. Therefore, according to
information economics, the capital market should be more efficient in theory post liberalization.
The financial market becomes more efficient because that improved risk sharing post-liberalization
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should decrease the cost of equity capital and increase investment. Financing constraints make external
finance more costly than internal finance and cause investment to be sensitive to cash flows. At the same
time, equity market liberalization directly reduces financing constraints in the sense that more foreign
capital becomes available, and foreign investors could insist on better corporate governance, which
indirectly reduces the cost of internal and external finance. Hence, the cost of capital could go down
because of improved risk sharing or because of the reduction in financing constraints or both. Moreover,
better corporate governance and investor protection should promote financial development and hence
growth.
Following, the market subjects will change their behaviors so as to make the financial market
become more efficient. Against the background of liberalization, as requires of market entry become
loosened, the competition between the market and the institutions becomes increasingly fierce. The
resulting prosperous environment creates the need for more efficient intermediation and the offering of
more sophisticated financial instruments. These and other developments can not only decrease the
transaction cost, increase liquidity and avoid risks, but also can increase the presence of market makers
and reflect more information, hence further enhance the transparency and the fluidity of the financial
market. The theory of asset portfolio says that the correlation of all kinds assets that a investor invest
decreases, then this investor can use this condition to establish an asset portfolio of lowest risk at given
returns or of highest returns at given risk. So, the liberalization of capital market enables the investors to
invest beyond a country’s national boundaries, which can decrease the risks of the portfolios by reducing
the correlation of the basic securities.
Additionally, the capital account openness can mitigate the intervention and control of government
on the financial market. So, the operation mechanism of financial market will be more active and
marketed, which is helpful to establish strong efficient financial market. The reasons lie in: first, when
government intervention abolished, the price of financial products and interest rate can reflect the real
supply and need of financial resource better, which is beneficial to stimulate the investors, so as to
increase the fund supply and expand the financing scale; second, the reduction of government
intervention can improve the situation of government monopoly and intervention in fund allocating. So,
the society has more chances and be more equitable to supply fund. Also, this will help these enterprises
in high productive get more fund, and the same time squeeze out those enterprises in low productive, so
as to improve the utilization of fund; last but not least, the elimination of capital control makes it a
mainstream to be financial market globalization. This is useful for the international capital movement,
thus to enhance the pricing efficiency of the capital market.
It deserve to note that, during the process of capital account openness, those polices to assure the
success of reform become the institutional guarantees for the financial reform; also, the huge capital
inflow can weeding out inefficient financial institutions, creating greater pressure for reform of the
financial infrastructure and supplying enough capital for resolving problems of bad loan. Moreover, the
risk sharing and diversifying are beneficial to enhance the stability of financial system.
There is much empirical evidence to prove that capital market liberalization will improve efficiency.
Coppejans and Domowitz (1996) employ the random return of the stock to investigate the variation of
the market efficiency and conclude that post the stock market liberalizing, the predictability of the return
declines, namely, the market efficiency enhancement. Levine and Servos(1998) study the stock market
development in 16 emerging countries after liberalizing their capital account, the result demonstrates
that when releasing capital control, those index relative to securitize market such as market scale,
liquidity and internationalized become better. Moreover, Kim & Singal (2000a, 2000b), using
variance-ratio tests and GARCH models, study 11 emerging countries and find that, in general, market
liberalization improves efficiency. The research of Stulz (1999) and Mishkin (2001) gives the same
result. While, they discover the mechanism is that the liberalization of the stock market improve the
transparent to the public, which can reduce the adverse selection and moral hazard, so as to alleviate the
market liquidity. Finally, Lines 2005 testes that the free move of the international capital will trigger
more furious competition and enlarge the financial depth, which will also enhance the efficiency of
financial system as well as to improve the development of the financial market. As for the reasons, some
researchers sum up as the arbitrage activity of foreign investor s, but some others consider it as the
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increase of trade frequency owing to the market open.
4 Evolution of the theory
According to the previous, it seems to conclude that there is a benign relationship between the
financial system efficiency and the effects of capital account openness. That is, a country begins its
liberalization with efficient financial system may enjoy the effects of economy growth, and the capital
account openness can prompt the efficiency of the financial system. But the practice of those reforming
countries has demonstrated something different. For example, Hungary has reap the benefits though it
began its liberalization with a relatively inefficient domestic financial system, while some developed
countries with matured financial system have not reap the reform fruits, rather, they suffered financial
crises and undermined their financial system efficiency. What makes the gap between the practice and
the theory?
Some researchers consider the reason is that the development of financial system is not linear with
the effects of the capital account openness. For example, Philippe Aghion et. al (2004) explain in their
paper that in the process of capital account openness, it is economies at an intermediate level of financial
development - rather than the very developed or underdeveloped - that are the most unstable; also, it is
still these ones at an intermediate level of financial development that are mostly destabilize, inducing
chronic phases of growth with capital inflows followed by collapse with capital flight. The reason, they
claim is that: at very high levels of financial development, most firms’ investment is not constrained by
cash flow, so shocks to cash flow are irrelevant. On the other hand, at very low levels of financial
development, firms cannot borrow very much in any case and therefore their response to cash-flow
shocks will be rather muted- extra cash means more investment but only a little more. Therefore shocks
will die out without causing any great turmoil. It is then at intermediate levels of financial development
that shocks to cash flow will have an effect intense enough to be a source of instability. In this sense,
Philippe Aghion et.al (2004) claim that slumps should be seen as part of a normal process in economies
like these which are both at an intermediate level of financial development and in the process of
liberalizing their financial sectors.
Another reason, researchers stress much is that the interaction of the efficiency of financial system
and the effects of capital account openness is affected by the institutional quality. Recently, Menzie D.
Chinn and Hiro Ito (2006) construct a financial development mode with 108 countries and accounting
framework over 1980 to 2000 to investigate the relationship of the financial development and the capital
account openness. They argue that capital account openness contributes both directly and in an
interactive manner with the legal and institutional development to the financial development. However,
they identified that capital account openness can lead to financial development only if the economic
system is equipped with a reasonable level of legal and institutional development. Meanwhile, they
identified that there exist thresholds of financial development for a country to reap the benefits of the
capital account openness. In a similar vein, Klein (2005) has ever advanced that institutional quality
affects the extent to which domestic savings are protected from expropriation as well as the premium
demanded by foreigners when investing in the domestic economy, therefore, the effects of capital
account openness depends upon the institutional quality. In fact, he has provided evidence of an
invented-U shaped relationship between the economy growth effects of the capital account openness and
institutional quality with 71 countries and over 1976 to 1995. According to his study, those countries
tend to benefits significantly from capital account openness are mostly upper-income countries.
Additionally, we must be aware that all the analysis in section 2 and 3 we make just under the
background of capital control and in a static way. However, when liberalizing, not only the policies of
capital but also the economic operation mechanism will change. Moreover, as those developed countries
have completed the reform, the operation mechanism of world financial market has changed too. The
study of George Aleksandra and Jun Qian (2005) has also confirmed this. They found in their study that
owing to the lack of funds and information, the financial intermediaries is effect in monitoring and
rationing credit by lowering the loan rate to induce the agents to invest in socially efficient projects in
the closed economy. While liberalizing, the free flow of the international capital will increase the capital
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availability and make the loan rate towards to the world rate level, thus increase the opportunity cost for
financial intermediaries to do the same and make them exit financial market. Further more, George
Aleksandra and Jun Qian (2005) state that efficient financial intermediaries may become inefficient
following the capital account openness when its country accesses global capital markets at high interest
rates. As the same, an inefficient financial intermediary in the closed economy will become efficient
when at low interest rates situation. Therefore, an efficient financial system in the closed economy is
neither necessary nor sufficient for a capital account openness to be success, and the capital account
openness may improve or worsen the efficiency of the financial intermediaries, as the practice has
demonstrated.
5 Conclusions
Many developing countries that liberalized their capital accounts had suffered financial crisis. One main
reason is that they were went without a robust and developed financial system, such as crises in Latin
America (Mexico) in 1994–1995 and East Asia in 1997–1998, respectively. In Mexico, apart from large
scale capital inflows and worsening macroeconomic conditions, a weak financial system contributed
significantly to the country’s crisis. Similarly, in the East Asian crisis, these affected countries were also
unable to address structural weaknesses, a notable one of which was inadequate financial regulation and
prudential supervision in the face of huge capital inflows.
So, for those counties going to experience economic liberalization reform, we would like to suggest
that capital account openness is really beneficial to the economy and the promotion of the financial
system efficiency. While, even a successful liberalization can not assure it must be beneficial, therefore,
for any country, it need an active and passionate attitude towards liberalization reforms, at the same to
keep cautious as well as calm. Meanwhile, an efficient financial system is indeed important to the
economic growth effects of capital account openness, but an efficient financial system in the closed
economy is neither necessary nor sufficient for a capital account openness to be success, and postponing
liberalization until financial system efficiency has been enough improved could reduce the pace of
economic growth. Hence, we should continuously strengthen the efficiency of our financial system to
insure the effects of capital account openness, but we should not begin our liberalization reform until the
financial system become efficient. Moreover, we know from the evolution of the theory the importance
to coordinate the financial development, the capital account openness the economic operation and
institutions and some other polices. Thus, for those above countries to gain from the reform of the
capital account openness and the improvement of the financial system, the key points to assure the
reform success is to make the reform polices coordinate with each other, match them with the economy
operation mechanism. At the same time, these reform polices need to be performed in a dynamic way as
well.
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