Ebook Financial Development and Financial Liberalization in Asia: Thresholds, Institutions and the Sequence of Liberalization
The Asian crisis of 1997-98 confronted policy makers with the conundrum of financial globalization. While more open financial markets can contribute to economic development, it is the openness of financial markets that can make developing countries more vulnerable to financial disruptions (Kaminsky and Schmukler, 2001a,b, 2002 and Schmukler 2003).
Despite the experience of the 1990’s, East Asian policy makers do not appear to have abandoned the path of financial liberalization. Rather, as is best exemplified by the Chiang Mai Initiative, they have re-emphasized economic development through more integrated financial markets in the region. The progress in financial development has occurred against a backdrop of regional trade arrangements. As Pomfret (2005) documents, the Asian currency union also started being discussed in the region, signifying the importance of how to sequence liberalization policies. In sum, the debate is not whether to liberalize, but that of how to liberalize. This study attempts to inform that debate.
A common view is that capital account liberalization leads to the development of financial markets that channel funds to borrowers with the most productive investment opportunities. Theory suggests several mechanisms for this occurrence. First, financial liberalization may mitigate financial repression in protected financial markets, allowing the real interest rate to rise to its competitive market equilibrium (McKinnon, 1973; Shaw, 1973). Second, the removal of capital controls allows domestic and foreign investors to engage in more portfolio diversification, thereby reducing the cost of capital, and increasing the availability of funds. Third, and not least, the liberalization process usually increases the efficiency of the financial system by weeding out inefficient financial institutions and creating greater pressure for a reform of the financial infrastructure, alleviating information asymmetry issues such as adverse selection and moral hazard (Claesens et al., 2001; Stulz, 1999; Stiglitz 2000).
The link between financial liberalization and financial development is not unambiguous, however. One common argument is that to benefit from more open cross-border financial transactions, financial systems need to be equipped with reasonable legal and institutional infrastructure. Specifically, in economies where the legal system does not clearly define property rights or guarantee the enforcement of contracts, the incentives for loan activities can be limited. Legal protections for creditors and the level of credibility and transparency of accounting rules are also likely to affect economic agents’ financial decisions. La Porta, Lopez-de-Silanes, Shleifer, and Vishny (hereafter LLSV, 1997, 1998) and Levine (1998, 2002) show that low levels of shareholder rights are associated with poorly developed equity markets (especially in French civil law countries), while Claessens, et al. (2002) and Caprio, et al. (2004) find that greater creditor rights are positively associated with financial intermediary development.
The ambiguity can be empirically reconciled by incorporating explicitly the level of legal and institutional development. I hypothesize that financial liberalization can lead to financial development only if the economic system is equipped with a reasonable level of legal and institutional development.
In this paper, I also examine another oft-discussed issue related to the sequence of liberalization, that is, the order of liberalization in goods and financial markets. The prominent work by McKinnon (1991) argues that liberalization in the trade sector must precede liberalization in the capital account transactions. Rajan and Zingales (2003) argue that financial liberalization can lead to financial development only when the economy is open in both cross-border trade and capital flows because the economic openness can lead to weakening the political power of incumbent financial institutions to oppose further financial development. Aizenman and Noy (2004), while investigating countries’ motivations for capital controls, find that financial openness and trade openness are bidirectional though the causality from the former to the latter is found to be more pervasive than the other. Given the ongoing debates over the manner in which to implement financial and real integration in Asia, I think this question is of central importance.
This paper conducts a panel data analysis using the dataset encompassing 87 developing and emerging market countries (including 15 Asian countries) and twenty years ranging from 1980 to 2000. In the econometric analysis, I pay special attention to financial development in the equity market sector and attempt to highlight any special attributes of the Asian region.
The empirical results suggest that a higher level of financial openness contributes to the development of equity markets, but only if a country is equipped with a certain level of legal and institutional development. This finding is applicable not only to the group of less developed countries in general, but also to that of the Asian economies. It can be further surmised that many of the Asian emerging market countries have been more successful in reaping the benefits of financial liberalization because of their relatively higher levels of legal and institutional development. Higher levels of bureaucratic quality, and of law and order, as well as the lower levels of corruption, have enhanced the effects of financial opening in fostering the development of equity markets for less developed countries in general, while only the absence of corruption and a high index of law and order matter for the Asian countries. As for the issue of the sequencing, the liberalization in cross-border goods transactions is found to be a precondition for capital account liberalization among all the sample groups. When the endogeneity of financial openness is accounted for using trade openness as an instrument, it is confirmed that financial liberalization leads to financial development.
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