Financial Integration and Deepening: Are Poor Countries Lagging?

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1 Financial Integration and Deepening: Are Poor Countries Lagging? Mark M. Spiegel Vice President Economic Research Federal Reserve Bank of San Francisco Prepared for conference on Capital Flows, Monetary Policy and Current Issues in International al Finance April 2007, Paris. Views expressed are my own and do not necessarily reflect those of the Federal Reserve System

2 Outline I. Financial Depth and Macroeconomic Performance III. Financial Integration and Macroeconomic Performance IV. Development of Domestic Securities Markets V. Policy Conclusions

3 I. Financial Depth

4 Measures of Financial Depth Cross-country measures of financial depth tend to be crude Intermediation taking place relative to level of economic activity Liquid liabilities as a share of GDP Domestic Credit from banking sector Domestic Credit to private sector

5 Positive correlation between financial depth and income LBN Liquid Liabilities (% GDP) ERI CHN JOR MYS GRD THA VUTEGY SYC ATG MAR DMA BRB MUS KOR SYR LCA VCT PAN DJI CPV CZE ETH INDALB URY HRV VNM PHLDZA SVK HND TUN STP ZWE SUR BTNBOL BIH DOM BLZ GMB IDN LKA MDV ZAF MNG PAK TONFJI BGR HUN KEN BGD NIC FSM JAM SLV TUR IRNCRI POL TTO YEMWSM NPL CHL EST COL BDI BEN GHAGTM LVA MLIMDAMKD ARG BFA MOZ SLB SEN LSO MEX BWA LTU OMN GNB MDG MWI NGA PER PRY UKR COM PNG RUS TGO CIV BRA KHM LAO CMR ECUROM SLE TZA ZMB RWA UGA VEN CAF COG GIN AZE ARM GAB SWZ KAZ BLR LBR SDN NER TCD MRT GEO ZAR TJK GNQ CHE JPN NZL CAN AUS ISL DNK SWE NOR USA GDP per Capita ( )

6 Liquid Liabilities (% of GDP) Percent (%) s 70s 80s 90s Current High Income OECD Countries: GNI per capita > $10,066 Middle Inco me Countries: GNI per capita between $825 and $10,065 Low Income Countries: GNI per capita < $825

7 Domestic Credit Provided by Banking Sector (% of GDP) Percent (%) s 70s 80s 90s Current High Income OECD Countries: GNI per capita > $10,066 Middle Inco me Countries: GNI per capita between $825 and $10,065 Low Income Countries: GNI per capita < $825

8 Domestic Credit to Private Sector (% of GDP) Percent (%) s 70s 80s 90s Current High Income OECD Countries: GNI per capita > $10,066 Middle Inco me Countries: GNI per capita between $825 and $10,065 Low Income Countries: GNI per capita < $825

9 Stylized Facts Wealthy countries have more financial depth Financial depth in wealthy countries has been increasing over time Poor country performance has been mixed, but by and large poor countries have been falling behind

10 Why should we care? Number of theoretical reasons why financial depth may enhance economic performance Reduced information costs Mitigate risk exposure Pools savings to capitalize on potential economies of scale Countries with more financial depth appear to exhibit superior economic performance

11 Positive correlation between financial development and subsequent growth CHE Liquid Liabilities (% GDP) ZMB ZAR JPN ITA USA ZAF FRA JOR BRB SWE NLD DZA NZL AUT CANOR DNK PAK FIN AUS SYRISL JAMFJIEGY KEN GUY MEX MAR TTO TUN SUR THA CIV VENPHL ARG PAN MWI HND BRAIND GHAGMB ECU CAF GTMCOG BOL CRI CO L LKAIRQ PERSLV URY MDGTGOUGA SDN PRY DOM NIC SEN GABCMR CHL SLE HTI MLI MRT BEN NGA BDI RWA SWZ NPL BFA NER TCD TUR MYS KOR IDN Average Subsequent Growth ( )

12 Positive relationship between financial development and growth Serious causality issues, but results seem robust Impact appears to be on total factor productivity, rather than factor accumulation y = Af ( K, L, T,... ) Bodes well for sustainable growth improvements through development of financial sector [Young (1992)]

13 II. Financial Integration

14 Concepts of financial integration de facto financial integration Actual intensity of links to international capital markets de jure financial integration Degree to which policies encourage enhanced links to foreign capital markets Usually associated with severity of restrictions on capital movements into and out of country

15 Discrepancies between two Latin America concepts Countries often closed according to de jure measures Often have relatively large volumes of international capital flows (de( facto) Africa Number of countries have relatively open capital account policies Still receive relatively small international capital flows

16 Measures of de facto financial integration Gross foreign assets and liabilities relative to GDP Typically CPIS data set Correlation between consumption and output Should be negatively related to international financial integration

17 High income countries are more integrated by de facto measure Total Foreign Assets & Liabilities (% of GDP in 2003) Percent (%) High Income OECD Countries: GNI per capita > $10,066 Middle Inco me Countries: GNI per capita between $825 and $10,065 Low Income Countries: GNI per capita < $825

18 Measures of de jure financial Combinations of: integration Intensity of official restrictions on capital flows Prevalence of use of multiple exchange rates Requirements of surrender of export proceeds Chinn-Ito (2007)

19 High income countries also more integrated by de jure measure Dejure Capital Account Openness (Subtitle) Percent (%) s 70s 80s 90s Current High Income OECD Countries: GNI per capita > $10,066 Middle Income Countries: GNI per capita between $825 and $10,065 Low Income Countries: GNI per capita < $825

20 Why should we care? Channels for financial integration to affect economic performance Increased investment from decrease in capital costs Technology transfer from developed countries Development of domestic financial sector Increased risk management and more specialization in production Improved macroeconomic policies However, unlike financial depth, impact of financial integration is much more mixed

21 Little correlation between de jure capital account openness and subsequent growth de jure Capital Account Openness LBN LBR ZMB ZAR NIC HND SAU MEX CAN DEU USA PAN KWT BEL HKG BOL ANT SWE CRI NLD ECU ARG AFG VEN LAO HTI IDN AUT ISR JAMDNK AUS ITA TTO SUR NOR JPN THA SGP MYS PHL BFA URY PER MDGTGO NER SEN TCD GAB CIVCMR MRT BENCOG IRL SLE SOM GHAGIN KEN JOR UGA GTMGUY SLV NGA TZAF NZL BDI ETH RWA IRN MWI MLI NPL MAR GRC TUR PRY FIN ESP TUN IND ISL DOM PRT FRA CYP KORCHN CAF SDN CHL DZA CO EGY BRA GBR SYR PAK VNM L LKAIRQ Average Subsequent Growth ( )

22 Parametric studies also find weak Study relationship # of Countries Years Effect on growth Alesina, et al (94) No effect Grilli and Milesi-Ferretti (95) No effect Quinn (97) Positive Kraay (98) No effect Rodrik (98) No effect Klein and Olivei (00) Positive Chanda (00) Mixed Arteta (01) Mixed Bekaert, et al (01) Positive Edwards (01) No effect O donnell (01) No effect Reisen and Soto (01) Mixed Edison, et al (02) Mixed Edison, et al (02) No effect

23 Reasons for weak relationship Integration may foster increased capital accumulation, but not total factor productivity growth TFP growth is bulk of cross-country country growth differences Integration may increase exposure to financial crises Researchers may have failed to find relationship due to endogeneity issues

24 Integration and macroeconomic volatility Increased integration allows risk to be shifted to world markets Can separate output and consumption risk Because consumption risk (which we care about) is not as closely connected to output risk, we can choose a riskier (but perhaps more valuable) output bundle Predicts increased specialization and perhaps increased output volatility but should also see reduced consumption volatility

25 Financial integration and volatility [Prasad, et al (2003)] More financially integrated Less financially integrated Output (Y) Income (Q) Pvt. Consumption (C) C+G (C+G)/Q

26 Evidence from geography de jure integration likely to be endogenous Countries may respond to financial crises by imposing capital restrictions [e.g. Malaysia (1997)] Rose and Spiegel (2007) use distance from major international financial centers [New York, London Tokyo] as proxy for financial remoteness Finds strong positive relationship between financial remoteness and macroeconomic volatility

27 Figure 1: Volatility and Remoteness 15 Liberia Iraq Equatori Suriname Business Cycle Volatility Kazakhst Kyrgyzst Ukraine Albania Tajikist Afghanis Azerbaij Congo, R Turkmeni Georgia Chad Moldova Djibouti Mozambiq Bahrain Burundi Macao Trinidad Sierra LVanuatu Yemen Somalia Haiti Laos Solomon Qatar Zimbabwe Uruguay Venezuel Russia Mali Guinea-B Eritrea Bulgaria Morocco Lebanon Gambia, Nigeria Malawi Argentin Palau Kuwait Ghana Sudan Zambia Turkey Korea, R Lithuani Philippi Cape Papua Uzbekist Senegal Singapor Ver Ne Central Botswana St. Kitt St.Vince Togo Uganda Micrones Thailand Madagasc Lesotho Bosnia a Dominica Armenia Bhutan Maldives Romania Hong Kon Indonesi Ethiopia Korea, Bermuda D Niger Bahamas Honduras Belarus Belize St. Luci Saudi Ar Congo, Samoa D Sao Cambodia Gabon Tome Mexico SyriaBurkina Estonia United Peru Rwanda A Dominica AntiguaIsraelMalaysia Banglade Cameroon Iran Costa Jordan Ri Netherla Barbados Brunei Cote d`i Fiji Luxembou Puerto R Tonga Swazilan Latvia Iceland Macedoni Malta Mauritan Guinea Kiribati Chile Namibia Mauritiu Serbia a Ireland Taiwan Cuba Algeria Nicaragu Cyprus China Grenada Egypt Oman Comoros Hungary Nepal Finland Brazil India Tanzania Mongolia Panama Denmark Canada Colombia Ecuador Kenya Netherla Norway Vietnam Belgium Switzerl Czech Croatia Pakistan Sri Lank Re Poland Paraguay Portugal JamaicaEl Salva Germany France Guatemal AustriaSpain Slovak Italy R Greece Benin Australi New Zeal Slovenia Sweden Tunisia South Af Bolivia International Financial Remoteness Key Variables,

28 III. Bond Finance

29 Increased attention to bond finance subsequent to 1997 Asian crisis Perceived that bond finance could provide a substitute form of intermediation during crises Greenspan: Spare tire comment This finding is largely discredited Evidence suggests that bank and bond finance are complements, rather than substitutes [Eichengreen[ Eichengreen,, et al (2004)] Ex.: Banks provide bond underwriting services

30 Arguments for encouraging local currency bond finance Developing countries, particularly in Asia, considered to be over-banked Borrowing in local currency could mitigate borrower exposure to currency risk Original sin precludes borrowing in local currency for investors in countries lacking thick local currency bond markets

31 Bond market shares suggest Asia behind Latin America As early as 1995 (before crisis) World Bank study encouraged Asian bond development 2003 Asian bond Fund launched by EMEAP Members committed to investing US 41 billion in Asian sovereign bonds Larger private bond purchases planned, but not finalized Idea is to increase depth of domestic bond markets

32 Large share of Latin American volume is public debt Domestic Bond Markets as a Share of GDP

33 Determinants of bond market depth Eichengreen,, et al (2004) Examined characteristics associated with increased bond market volume Country size (scale effects) GDP per capita (wealth) Exports/GDP (openness) Cost of contract enforcement (decreasing)

34 After controlling for country characteristics, Asia is ahead!

35 Questions for EMEs Merits of local currency bond finance are difficult to quantify Costs of encouraging development of these markets are real Usually could float debt offshore more cheaply Unclear that intervention is motivated Economies of scale suggest that some smaller economies incapable of developing Are government bonds substitutes or complements for private issues?

36 Conclusion Robust evidence of a positive relationship between financial deepening and growth Much weaker evidence that international financial integration enhances economic performance Some evidence that integration positively correlated with growth among countries pursuing good policies Little evidence supporting intervention encouraging local currency bond markets Bond markets should develop along with, not at expense of, development of domestic banking sector

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