We analyze output growth and risk as the joint outcomes of financial liberalization. Using an industry panel of 55 countries over 45 years, we find that financial liberalization results simultaneously in higher growth and in higher growth variability, measured both as the volatility and the left skewness of the growth process. These effects are stonger in industries that are more externally dependent and face better growth opportunities. Some of the effect of liberalization on growth goes through the channel of increased risk, implying that treating growth and risk independently may overestimate the direct growth effect of liberalization. We also find that the growth benefits of financial liberalization and its costs associated with higher risk are mitigated by strong institutions.
The recent experience of many emerging economies with financial liberalization has generated considerable research interest in the benefits and costs of this process. To begin with, there seems to be little doubt about the positive effect of financial liberalization on the economy(s long-term rate of growth. For example, Bekaert et al. (2005) show that equity market liberalization increases subsequent average annual real economic growth by about 1%, and effects of similar magnitude have been documented at the sector level (Gupta and Yuan (2009)). At the same time, there is a strong perception that foreign capital increases volatility both in the financial markets and in the real economy (Stiglitz (2000)). Empirical research into this question has provided some evidence confirming this view (Kose et al. (2003), Levchenko et al. (2009).
However, the literature that has looked at the effect of liberalization on the growth process 1) defines output risk only in terms of the volatility of output growth, and 2) looks independently at growth and risk. The first approach is questionable given persistent arguments - dating back to Lucas (1987) - that the welfare benefits of removing all of the business cycle volatility are miniscule. At the same time, Barro (2006) estimates, within a class of models which replicate how asset markets price consumption uncertainty, that individuals are willing to pay a high premium in exchange for eliminating all chances for rare, large, and abrupt macroeconomic contractions. To the extent that output and consumption risk are not completely uncorrelated, higher moments of output growth should capture better the growth risks associated with negative welfare implications. The second approach is not fully convincing either from a theoretical standpoint as the evolution of growth and risk must surely be the outcome of similar processes. Therefore, a more convincing empirical test would allow for the simultaneous determination of all moments of output growth.
