FINANCIAL OPENNESS LEADS TO DEEPER DOMESTIC FINANCIAL MARKETS
Analysis of data on 145 countries for the period 1974-2007 shows that domestic
financial markets are deeper and broader in depth in countries that are highly integrated
in the world’s capital markets.
According to research by César Calderón and Megumi Kubota – presented to the
Royal Economics Society’s 2009 Annual Conference at the University of Surrey – in
general, financial openness causes both an expansion in private credit, bank asset,
stock market and private market development, and efficiency in the banking system.
As an example, doubling the degree of financial openness — say, by doubling the ratio
of foreign liabilities to GDP — increases the ratio of bank deposits to GDP by 6.5%
while increasing the ratio of stock market capitalisation to GDP by 25%.
The rising integration of advanced and emerging market economies to international
capital markets has led to a substantial flow of foreign capital in advanced economies
and (few) large developing countries. It has been argued that rising financial integration
may propel growth through the development of financial markets.
Financial openness could raise the depth and the scope of domestic financial markets
by lowering the borrowing costs and improving the quality and availability of financial
services. Moreover, a sudden cut in the access to the world capital markets (especially,
to emerging market economies) may lead to a lower cross-border bank lending and to
either short-term liquidity constraints or long-term sustainability problems for the
domestic banking system.
The goal of this paper is to test whether rising financial openness has increased the
depth and breadth of domestic financial markets – as captured by both an increasing
size and depth of deposit money banks and other financial institutions, and deeper
stock and bond markets. The researchers also test whether the effects from financial
openness may depend on the country’s degree of institutional quality, investor
protection and trade openness.
This paper is the first to evaluate the effects on domestic financial development of
‘outcome measures’ of financial openness such as stocks of foreign assets and
liabilities. So far, the literature has focused on policy indicators that measure the lack of
restrictions to perform cross-border trade.
The researchers carry out a regression analysis for 145 countries using an annual
database for the period 1974-2007. Their qualitative finding is that the domestic
financial depth has greater depth and scope in countries that are highly integrated in
the world capital markets. In general, financial openness causes both an expansion in
private credit, bank asset, stock market and private market development, and efficiency
in the banking system.
The quantitative estimates are economically significant. For instance, doubling the
degree of financial openness – say, the ratio of foreign liabilities to GDP doubles –
increases the ratio of bank deposits to GDP by 6.5% while increasing the ratio of stock
market capitalisation to GDP by 25%.
Previous work by these researchers found that the structure of external assets and
liabilities play a significant role in identifying forces that enhanced or mitigated shocks
to the real exchange rate. This study finds an analogous result: the accumulation of
risky assets (direct investment and portfolio equity) may lead to an expansion in bank
credit and bank deposits while the hoarding of riskless assets (debt and reserve assets)
raises bank credit but has no effect on bank deposits.
Furthermore, the researchers assess whether the different impact of accumulating risky
vis-à-vis riskless assets depends on the level of institutional quality, the extent of
investor protection and the degree of trade openness of the domestic economy.
In short, their finding shows that rising financial openness will enlarge the size of activity
of financial intermediation, improve efficiency in the banking system and contribute to
deepen private bond markets in countries both with moderate to high levels of
institutional quality and investor protection, and with high trade openness.
The numerical finding is a differentiated response to an increase in the ratio of net
foreign assets to GDP. It may lead to: (i) a reduction (an increase) in bank deposits of
9.2% (3%) in countries with low (high) levels of institutional quality, (ii) a decline (rise)
by 6.5% (0.7%) in countries with low (high) degrees of investor protection; and, (iii) a
reduction (jump) in bank deposits of 5.2% (0.1%) in countries with low (high) degrees of
trade openness.
ENDS
‘Does Financial Openness Lead to Deeper Domestic Financial Markets?’ by César
Calderón and Megumi Kubota
César Calderón, Office of the Chief Economist, Latin American Region, World Bank,
1818 H Street NW, Washington DC 20433, USA. (email: ccalderon@worldbank.org)
Megumi Kubota, Department of Economics, University of York, Heslington, York YO 10
5DD, UK (email: mk540@york.ac.uk)
The views expressed in this paper are those of the authors, and do not necessarily
reflect those of the World Bank or its Boards of Directors.