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EC7096 Financial Systems and Economic Performance Lecture 17

Removing obstacles to financial development:

Policies and institutions:

Financial Repression/ liberalization

Legal and institutional factors

What if institutions and policies are endogenous?

Political economy factors (Rajan and Zingales)

Financial development constitutes a potentially important mechanism for long run growth Frontier of the literature is now shifting towards finding out why some countries are more financially developed than others

Four hypotheses

1. Initial Endowments 3. Political economy (RZ)

2. Legal origin

4. Economic


Private credit as % of GDP

The first two hypotheses emphasise initial conditions that are time invariant


S. Korea


Korea as % of OECD 15
18.0 53.0

Cannot explain South Koreas spectacular performance since 1960s

1960 2004

12.3 98.2

66.0 185.0

The other two emphasise factors that may change over time, such as:

Openness Economic institutions

World average

South Asia

Latin AmericaCaribbean 37%

Baltagi et al provide evidence on the last two hypotheses that could potentially explain cases like South Korea

Increase in private credit to GDP during 1960-2004



When financial markets are under-developed two types of incumbents enjoy rents:

Established industrial firms (industrial incumbents)

Are in a privileged position to obtain external finance, because they have collateral

and reputation New entrepreneurs with profitable opportunities have to team up with incumbents to obtain finance

Financial incumbents
Have an informational advantage due to relation based finance Have monopoly power in providing external finance to firms, because of weak

enforcement and poor disclosure

Financial development:
improves transparency and enforcement and reduces barriers to entry New entrants can operate without help from incumbents Threatens the rents of incumbents because it breeds competition

Financial and industrial incumbents likely to oppose financial development

Opening either trade or capital account alone will intensify incumbents opposition:

Trade liberalisation with protected capital markets:

reduces industrial incumbents competitiveness and profits, increasing pressure for cheap loans to defend their domestic position; their opposition to fin dev likely to increase Incumbent financiers opposition to fin dev likely to remain unchanged, relation based financing favours dealing with existing industrial clients Industrial incumbents opposition to fin dev unchanged (without free trade there is little need for tapping new sources of finance) Financial incumbents resistance to fin dev is stronger, because they are now forced to compete for their largest and best clients

Free capital flows with protected product markets:

Opening both product and capital markets removes incumbents opposition to financial development:

Forces incumbents to make the best of liberalised markets in order to cope with competitive pressures

Lower profits of industrial incumbents forces them to tap international capital markets for cheaper finance and to press for improved access to domestic finance Incumbent financiers lose best clients to foreign competition and are forced to seek new lending opportunities among young industrial firms, who are less known and more risky; they are therefore more likely to support improvements in transparency and disclosure

RZ highly plausible, but no theoretical model and what explains openness is unclear

Builds on endowment hypothesis but allows economic institutions to change over time

Dynamic political economy framework

Differences in economic institutions are the fundamental

cause of differences in development Economic institutions are social decisions that determine the incentives and constraints faced by agents
Growth promoting institutions emerge when political institutions (i) allocate power to groups with interests in broad based property rights enforcement (ii) create effective constraints on power holders and when there are few rents to be captured by power holders

To provide evidence on the determinants of financial development across countries and over time in a contemporary setting, taking on board the predictions of the two relevant hypotheses

To distinguish between the two hypotheses we use the specific mechanism in RZ i.e. simultaneous trade and capital account openness

We therefore test the following two hypotheses:


Do trade and capital account openness facilitate financial development?

Do they do this independently of each other or jointly?

Given the RZ prediction that opening one without the may be counter-productive it is important to distinguish the effects of simultaneous openness


Do economic institutions (e.g. rule of law) have an additional influence on financial development, over and above the two types of openness?
Evidence of the latter would suggest that openness is not the only mechanism of financial development

Equation 1:

ln FDit = 0i + ln FDit-1 + 1 ln Yit + 2 ln TOit + 3 ln FO it + 4 ln INSit + it

RZ requires 3 and 4 both to be positive (but RZ effect may also partly operate through INS). Equation 2: Add interaction term
ln FDit = 0i + ln FDit-1 + 1 ln Yit + 2 ln TOit + 3 ln FO it + 4 ln INSit + 5 {ln FOxlnTO}it + it

The (short-run) effects of trade and financial openness depend on the extent of financial and trade openness, respectively, as shown by the partial derivatives of financial development with respect to each of the openness variables

ln FDit 2 5 ln FOit ln TOit

ln FDit 3 5 ln TOit ln COit

Strictly speaking RZ requires 5 to be positive and 2, 3 zero or negative.

However, this may be too strict an interpretation of a
rather loose formulation. Also, once again, effect may partly operate through INS

Dependent variables (WDI and Beck et al): Liquid liabilities, private credit and domestic credit, stock market capitalisation, stock market turnover (all % of GDP)

and number of companies listed (% of population)

Trade openness: exports plus imports (% of GDP) from WDI Financial openness variables:

Financial Globalisation (foreign assets+ liabilities, % of GDP) from Lane and Milesi-Ferreti (2006) Financial Liberalisation Index from Abiad and Mody (2005) Chinn and Ito capital account liberalisation index

Institutional quality from ICRG: average of corruption, rule of law, bureaucratic quality, government repudiation of contracts and risk of expropriation

Control: Real GDP per capita (WDI)

Dynamic model allows dependent variable to partially adjust to equilibrium value Differences the model to:

Gets rid of country specific effects or any time invariant country specific variable Gets rid of endogeneity due to the correlation of country specific effects and the right hand side regressors Moment conditions utilize the orthogonality conditions between the differenced errors and lagged values of the dependent variable. Assumes that the original disturbances in (1) and (2) are serially uncorrelated and that the differenced error is MA(1) with unit root.

Two diagnostics are computed to test for first order and second order serial correlation in the disturbances. One should reject the null of the absence of first order serial correlation and not reject the absence of second order serial correlation. A Sargan test is performed to test the over-identification restrictions. Because too many moment conditions introduce bias while increasing efficiency, we restrict the moment conditions to a maximum of two lags on the dependent variable. E.g. in Table 2 with N=42 countries and T=22, This yields a Sargan statistic that is asymptotically distributed as Chi-squared with 42 degrees of freedom, i.e., 42 over-identification restrictions. On the other hand for the data set underlying Table 5 with N=31 countries and T=7, using all the moment conditions implied by the Arellano and Bond GMM procedure yields 13 over-identification restrictions.

The number of moment conditions increase with T.

EC7096 Lectures 15-18


EC7096 Lectures 15-18


EC7096 Lectures 15-18


EC7096 Lectures 15-18


EC7096 Lectures 15-18


EC7096 Lectures 15-18


EC7096 Lectures 15-18


Partial derivative of private credit w.r.t. trade openness:

-0.23 at mean level of financial openness +0.36 at minimum level of financial openness -0.54 at maximum level of financial openness

Partial derivative of private credit w.r.t. financial openness:

-0.05 at mean level of trade openness +0.46 at minimum level of trade openness -0.34 at the maximum level of trade openness

Financial openness more effective

The evidence in Baltagi et al (2009) suggests:

Trade and financial openness are robust mechanisms of financial development, irrespective of indicator used
However, the simultaneous openness hypothesis (RZ 2003) receives very little support

suggesting that a more nuanced openness or political economy story may be required to explain the variation of financial development across countries and over time

Economic Institutions have an additional independent influence on some, though not all, indicators (e.g. stock market liquidity, bank credit)

More theoretical work is needed to guide empirical work in this area. There is a lack of formal models of the political economy of financial development:

Andrianova, Demetriades and Xu (2011) examine the origins of financial development, drawing on successful cases from Europe and Asia (e.g. London, Amsterdam and HK) :
those found in current literature (e.g. role of monopoly power and rents)

Some of the insights of this work are intriguing, highlighting different mechanisms than