THE EFFECT OF CAPITAL THE EFFECT OF CAPITAL MARKET LIBERALIZATION MARKET LIBERALIZATION IN EASTERN EUROPE: IN EASTERN EUROPE:
ECONOMIC GROWTH OR ECONOMIC GROWTH OR FINANCIAL CRISISFINANCIAL CRISIS
MSc Student: LAVINIA CRISTESCUCoordinator: PhD. Professor MOISĂ ALTĂR
Bucharest, July 2008
- Dissertation Paper -
Academy For Economic Studies, Bucharest - Doctoral School of Finance and Banking (DOFIN)
CONTENTSCONTENTS
I. Introduction
II. Literature Review
III. Model Specifications
IV. Empirical Analysisa. The Data
b. Testing The Financial Liberalization Effect
V. Conclusions
VI. References
I. INTRODUCTIONI. INTRODUCTION
FINANCIAL LIBERALIZATION
OF EQUITY MARKETS
Openes international financing path
Decreases the cost of capital
Increases investment
Leads to a more rapid economic growth
Also, may lead to:
A decline in credit’s portfolio quality
An increase in financial fragility
Macroeconomic volatility to external shocks
FINANCIAL CRISES AND LOSSES
Positi
ve ef
fects
Negative effects
II. LITERATURE REVIEWII. LITERATURE REVIEW
Bekaert, Harvey and Lundblad (2005) – Capital market liberalization leads to 1% increase in the economic growth rate.
Kaminski and Reinhart (1998), Glick and Hutchinson (2001) – Banking and currency crisis propensity increases in the aftermath of financial liberalization.
Dell’ Aricia and Marquez (2004) – Financial liberalization helps developing the credit sector by reducing the bank’s incentive to monitor potential debtors.
Martin and Rey (2005) – In normal circumstances, liberalization has the positive role to generate capital inflows, to create diversification opportunities and to stimulate economic growth; in certain circumstances, liberalization can lead to financial crashes and a decrease in economic growth.
Ranciere, Tornell and Westermann (2006) – Financial liberalization has an positive influence on economic growth, although it increases the probability of financial crises.
Henry (2000) – Liberalization leads to an investment boom associated with a decrease in the cost of capital.
III. MODEL SPECIFICATIONSIII. MODEL SPECIFICATIONS
GROWTH MODEL (Panel, linear):
yi,t = αXi,t + βFLi,t + γIi,t + εi,t
Where:
yi,t – is the real GDP per capita growth (in logarithm)
Xi,t – is a set of standard control variables
FLi,t – is a dummy for financial liberalization, taking the value 1 if the country i is liberalized in year t and zero otherwise
Ii,t – is a dummy for crisis, taking the value 1 if there is a banking or currency crisis in the year t and zero otherwise
εi,t – is a random, gaussian component.
CRISIS MODEL (Panel, probit)
III. MODEL SPECIFICATIONSIII. MODEL SPECIFICATIONS
1 if W*i,t > 0Ii,t = 0 otherwise.
W*i,t = aZi,t + bFLi,t + ηi,t
1 with probability P(W*i,t > 0) = Φ(aZi,t + bFLi,t)Ii,t =
0 with probability P(W*i,t ≤ 0) = 1 - Φ(aZi,t + bFLi,t)
W*i,t is a latent, unobserved variable (the crisis probability) who depends on:
- Zi,t – a set of control variables- FLi,t – dummy financial liberalization- ηi,t – random, gaussian variable
Φ = cumulative distribution function of a standard normal
Two step estimation procedure
(Maddala (1983))
III. MODEL SPECIFICATIONSIII. MODEL SPECIFICATIONS
GROWTH MODEL
CRISIS MODELTREATMENT EFFECT MODEL
(Heckman (1978))
It measures the average causal effect of a binary variable (the treatment) on an output variable.
CRISIS DUMMY = The treatment
GROWTH REGRESSION = Output Equation
CRISIS REGRESSION = Treatment Equation (represents the probabiliy of receiving the treatment)
III. MODEL SPECIFICATIONSIII. MODEL SPECIFICATIONS
TWO STEP ESTIMATION PROCEDURE:
1. OBTAINING THE PROBIT ESTIMATES (ae, be)
2. COMPUTING AND ADDING TO THE GROWTH REGRESSION OF A HAZARD (hi,t) VARIABLE:
θ(ae Zi,t + be FLi,t) / Φ(ae Zi,t + be FLi,t), if Ii,t = 1hi,t =
- θ(ae Zi,t + be FLi,t) / [1 - Φ(ae Zi,t + be FLi,t)], if Ii,t = 0
Φ = cumulative distribution function of a standard normal
θ = probability density of a standard normal
ASSUMPTION: the errors are bivariate normal, but not independent
III. MODEL SPECIFICATIONSIII. MODEL SPECIFICATIONS
TOTAL AVERAGE CAUSAL EFFECT OF FINANCIAL LIBERALIZATION
Due to a change in the financial liberalization dummy from 0 to 1
E(yi,t | FLi,t = 1) - E(yi,t | FLi,t = 0) = βe + γe E[Φ(aeZi,t + be) – Φ(aeZi,t)]
Financial Liberalization Direct Effect Indirect Effect Total Effect
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISa. The Dataa. The Data
THE DATASET: 13 EASTERN EUROPE COUNTRIES TIME PERIOD: 1995 – 2007 (annual series) DATASOURCE: AMECO DATABASE, CENTRAL BANKS’ STATISTICAL
SERIES and BEKAERT and HARVEY’S DATABASE FROM DUKE UNIVERSITY
NO. COUNTRYFINANCIAL
LIBERALIZATION YEAR
BANKING CRISIS YEAR
CURRENCY CRISIS YEAR
FINANCIAL CRISIS
EU MEMBER FROM
1 BULGARIA*,c 1998 1995, 1996 1995 1995, 1997 2007
2 CYPRUS 2004 2004
3 CZECH REPUBLIK,c 1994 1997 1997 1997 2004
4 ESTONIA,c 1996 2004
5 HUNGARY*,c 1996 1995 1995 2004
6 LATVIA*,c 1996 1995 1995 2004
7 LITHUANIA,c 1996 1995, 1996 1995, 1996 2004
8 MALTA* 2004 1997 1997 2004
9 POLAND,c 1995 2004
10 ROMANIA,c 1997 2000 2000 2007
11 SLOVAKIA, c 1996 1998 1998 2004
12 SLOVENIA, c 1994 2004
13 TURKEY 1989 2000 2000 -
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISa. The Dataa. The Data
GROWTH DEPENDENT VARIABLE: REAL GDP PER CAPITA GROWTH – real_gdp_gr – log-difference of real GDP
per capita (stationary, ADF)
GROWTH DETERMINANTS: CONTROL VARIABLES:
INITIAL REAL GDP PER CAPITA – real_gdp – the ratio between real GDP (2000 current market prices GDP in national currency / GDP Deflator) and total population (stationary, ADF)
GOVERMENT SIZE – gov_size – ratio of final government consumption to GDP (2000 current market prices in national currency) (stationary, ADF)
POPULATION GROWTH – pop_gr – log-difference of total population (stationary, ADF)
INFLATION – inflatia – (log 100 + % National CPI all items) (stationary, ADF)
FINANCIAL LIBERALIZATION DUMMY – dummy_fl – measurement: official change in regulatory that allows foreigners to invest in domestic securities
FINANCIAL CRISIS DUMMY – dummy crisis – takes value 1 in the year where banking or currency crisis occurs
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISa. The Dataa. The Data
PROBIT DEPENDENT VARIABLE: Ii,t through the unobserved, latent variable W*i,t
PROBIT DETERMINANTS: CONTROL VARIABLES:
GOVERMENT SIZE
POPULATION GROWTH
INFLATION (1 LAG)
M2 / (INTERNATIONAL RESERVES – GOLD) – m2_res – the ratio between the monetary aggregate M2 and international liquid reserves (not stationary, ADF => first difference)
OPENESS TO TRADE – openess_trade – the ratio between (total exports and imports) to GDP – (not stationary, ADF => first difference)
REAL EFFECTIVE EXCHANGE RATE DETRENDED – rero_hptrend01 – real effective exchange rates (performance relative to 35 industrialized countries, EU) detrended using Hodrick Prescott filter, λ=100 (stationary, ADF)
DUMMY FINANCIAL LIBERALIZATION
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
TREATMENT EFFECT MODEL TWO STEPS ESTIMATION (STATA 9.1.)
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
THE ESTIMATORS’ CONFIDENCE LEVEL:
All the regressions’ coefficients are significant for a 95% level of confidence
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
TESTING THE PROBIT RESIDUALS: Distribution:
The probit residual is not normally distributed
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
Correlograms:
There is no evidence of serial residual correlation
There is no serial correlation of residuals squared
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
TESTING THE GROWTH REGRESSION RESIDUALS
Histogram Correlogram
The growth residuals are not normally distributed.
The growth residuals are not autocorrelated
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
TESTING THE GROWTH AND PROBIT RESIDUALS’ DEPENDENCE
εi,t = Ci,t + ηi,t + ei,t
New linear regression:
There is a dependence between the growth and the probit residuals
=> The two residual series are not normally bivariate and are not independent
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
TOTAL AVERAGE EFFECT OF FINANCIAL LIBERALIZATION:
DIRECT EFFECT βe 0.2197727
INDIRECT EFFECT γe E[Φ(aeZi,t + be) – Φ(aeZi,t)] 2.10817E-19
TOTAL EFFECT βe+ γe E[Φ(aeZi,t + be) – Φ(aeZi,t)] 0.2197727
On average, the total effect of capital market liberalization in Eastern Europe countries was a positive one
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
ESTIMATES DISCUSSION: GROWTH REGRESSION
REAL INITIAL GDP PER CAPITA (-0.289648, p < 1%) – economic growth rate is smaller for countries with a higher initial development level, consistent with Kormendi and Meguire (1985), Barro (1991, 1997), Sachs and Warner (1995).
GOVERMENT SIZE (3.9021292, p < 0.1%) – has a positive influence on growth, differs from Barro (1991, 1997), Sachs and Warner (1995) and is consistent with Caesseli (1996).
POPULATION GROWTH (7.0823379, p < 1%) – has a positive influence on growth, is consistent with Barro and Lee (1994) and differs from Kormendi and Meguire (1985), Mankiw (1992), Kelley and Schmidt (1995), Bloom and Sachs (1998).
INFLATION (-0.17143785, p < 0.1%) – leads to a decrease in economic growth rate, consistent with Barro (1997), Bruno and Easterly (1998), Motley (1998).
DUMMY FINANCIAL LIBERALIZATION (0.2197727, p < 0.1%) – leads to an increase in economic growth rate, consistent with literature.
DUMMY CRISIS (0.3893808, p < 1%) – consistent with literature (Ranciere, Tornell, Westermann (2006)), has a negative influence on growth.
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
ESTIMATES DISCUSSION: PROBIT REGRESSION
GOVERNMENT SIZE - (27.05248, p < 5%) – increases the crisis probability
POPULATION GROWTH – (127.7304, p < 5%) – increases the crisis probability
M2 / (INTERNATIONAL RESERVES – GOLD) – (-0.000115, p < 1%) – reduces the crisis probability and differs from the economic hypothesis.
INFLATION (1 LAG) – (1.216772, p < 5%) – increases the crisis probability
REAL EFFECTIVE EXCHANGE RATE HP DETRENDED (-0.140846, p < 1%) – reduces the probability of crisis.
From economical hypothesis (Kazaks (2000), Shatz and Tarr (2000) and Ranciere, Tornell and Westermann (2006), I first included in the probit non-linear regression Real Effective Exchange Rate Overvaluation (also 1 lag), defined as the percentage difference between Real Effective Exchange Rate and HP Detrended REER (IMF’s definition). However, it showed no statistical significant influence within the model. Instead, HP detrended REER has a negative statistical significant effect.
IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization
ESTIMATES DISCUSSION: PROBIT REGRESSION
FINANCIAL LIBERALIZATION DUMMY – (-1.60857, p < 5%)
- decreases the probability of occurring a financial crisis!
- the result differs from the ones obtained in the literature and from the economic hypothesis considerred.
FINANCIAL LIBERALIZATION HAD AN AVERAGE POSITIVE EFFECT ON GROWTH, COMPOSED BY:
A POSITIVE DIRECT EFFECT
A POSITIVE INDIRECT EFFECT – by decreasing the crisis probability
V. CONCLUSIONSV. CONCLUSIONS Conclusions:
Capital market liberalization had an average positive effect on economic growth in Eastern Europe
The other estimators’ influence is related to the economies’ specifications (emerging, most of them post-communist)
The conclusions can only be applied to the analyzed sample, a generalization is not accurate
Utility
The joint analysis of financial liberalization improves economic decision making
Further research:
Methodology improvement
Analysis of crises appeared in developed economies
Other determinants selection
VI. REFERENCESVI. REFERENCES1. Eichengreen, B. and C. Arteta (2000), „Banking Crises in Emerging Markets: Presumptions and
Evidence”, Institute of Business and Economic Research
2. Davis, E. P. and D. Karim (2007), „ Comparing Early Warning Systems for Banking Crises”, Economics and Finance Working Paper No. 07 - 11, Brunel University
3. Bekaert, G. and C.R. Harvey (2003), „Does Financial Liberalization Spur Growth?”, Journal of Financial Economics
4. Glick, R., X. Guo and M. Hutchinson (2004), „Currency Crises, Capital Account Liberalization, and Selection Bias”, UC Santa Cruz International Economics Working Paper No. 04 - 14
5. Ranciere, R., A. Tornell and F. Westermann (2003a), „Crises and Growth: A Re-Evaluation”, NBER Working Paper
6. (2006b), „Decomposing the Effects of Financial Liberalization: Crises vs. Growth”, Journal of Banking and Finance
7. (2007c) „Systemic Crises and Growth”, Quarterly Journal of Economics
8. Chinn, M. D. (2002), „The Measurement of Real Effective Exchange Rates: A Survey and Applications to East Asia” NBER Working Paper
9. Kaminsky, G. S. Lizondo and C.M. Reinhart (1998), „Leading Indicators of Currency Crisis”, IMF Staff Project
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11. Li, K. and N.R. Prabhala (2005), „Self-Selection Models in Corporate Finance”, Robert H. Smith School Research Paper No. RHS 06 - 020
12. Manning, A. (2004), „Instrumental Variables for Binary Treatments with Heterogeneous Treatment Effects: A Simple Exposition”, The Berkeley Electronic Press
VI. REFERENCESVI. REFERENCES13. Kaminski, G. and C. M Reinhart (1999), „The Twin Crises: The Causes of Banking and Balance-of-Payments
Problems”, The American Economic Review
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16. De Souza, L. V. (2004), „Financial Liberalization and Business Cycles: The Experience of Countries in the Baltics and Central Eastern Europe”, Deuche Bundesbank Discussion Paper
17. Goldstein, M., G. L. Kaminski and C. M. Reinhart (2000), „Assessing Financial Vulnerability”, pag. 11 – 32., Institute for International Economics
18. Bordo, M., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria (2000), „Is the crisis problem growing more severe?”, Blackwell Publishing Economic Policy
19. Hutchinson, M. M. and I. Neuberger (2002), „How Bad are the Twins? Output Costs of Currency and Banking Crisis”, Federal Reserve Bank of San Francisco Working Paper No. 02 – 02.
20. Shatz, H. J. and D. G. Tarr (2000) „Exchange Rate Overvaluation and Trade Protection: Lessons from Experience”, World Bank Policy Research Working Paper No. 2289
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22. Durlauf S. N., P. A. Johnson and J. R. W. Temple (2004), „Growth Econometrics”, Handbook of Economic Growth
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24. Kaminski, G. L. and S. L. Schmukler (2003), „Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization”, NBER Working Paper No. 9787
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