MSc Student: LAVINIA CRISTESCU Coordinator: PhD. Professor MOISĂ ALTĂR

1. Academy For Economic Studies, Bucharest - Doctoral School of Finance and Banking (DOFIN) THE EFFECT OF CAPITAL MARKET LIBERALIZATION IN EASTERN EUROPE: ECONOMIC GROWTH OR FINANCIAL CRISIS - Dissertation Paper - MSc Student: LAVINIA CRISTESCU Coordinator: PhD. ProfessorMOISĂ ALTĂR Bucharest, July 2008

2. CONTENTS • Introduction • Literature Review • Model Specifications • Empirical Analysis • The Data • Testing The Financial Liberalization Effect • Conclusions • References

3. I. INTRODUCTION Openes international financing path Decreases the cost of capital Positive effects Increases investment FINANCIAL LIBERALIZATION OF EQUITY MARKETS Leads to a more rapid economic growth Also, may lead to: A decline in credit’s portfolio quality Negative effects An increase in financial fragility Macroeconomic volatility to external shocks FINANCIAL CRISES AND LOSSES

4. II. 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.

5. III. 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.

6. 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) 1 if W*i,t > 0 Ii,t = 0 otherwise. III. MODEL SPECIFICATIONS • CRISIS MODEL (Panel, probit) W*i,t = aZi,t + bFLi,t + ηi,t • W*i,tis 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

7. III. MODEL SPECIFICATIONS GROWTH MODEL CRISIS MODEL Two step estimation procedure (Maddala (1983)) TREATMENT 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)

8. θ(aeZi,t + beFLi,t) / Φ(aeZi,t + beFLi,t), if Ii,t = 1 hi,t = - θ(aeZi,t + beFLi,t) / [1 - Φ(aeZi,t + beFLi,t)], if Ii,t = 0 III. 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: Φ= cumulative distribution function of a standard normal θ= probability density of a standard normal ASSUMPTION: the errors are bivariate normal, but not independent

9. E(yi,t | FLi,t = 1) - E(yi,t | FLi,t = 0)= βe+γe E[Φ(aeZi,t + be) – Φ(aeZi,t)] Financial LiberalizationDirect EffectIndirect Effect Total Effect III. MODEL SPECIFICATIONS TOTAL AVERAGE CAUSAL EFFECT OF FINANCIAL LIBERALIZATION Due to a change in the financial liberalization dummy from 0 to 1

10. IV. EMPIRICAL ANALYSISa. 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

11. IV. EMPIRICAL ANALYSISa. 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

12. IV. EMPIRICAL ANALYSISa. The Data PROBIT DEPENDENT VARIABLE: • Ii,t through the unobserved, latent variableW*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

13. IV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalization TREATMENT EFFECT MODEL TWO STEPS ESTIMATION (STATA 9.1.)

14. IV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalization THE ESTIMATORS’ CONFIDENCE LEVEL: All the regressions’ coefficients are significant for a 95% level of confidence

15. IV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalization TESTING THE PROBIT RESIDUALS: • Distribution: The probit residual is not normally distributed

16. IV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalization • Correlograms: There is no evidence of serial residual correlation There is no serial correlation of residuals squared

17. IV. EMPIRICAL ANALYSISb. 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

18. IV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalization TESTING THE GROWTH AND PROBIT RESIDUALS’ DEPENDENCE New linear regression: • εi,t = Ci,t + ηi,t + ei,t There is a dependence between the growth and the probit residuals => The two residual series are not normally bivariate and are not independent

19. IV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalization TOTAL AVERAGE EFFECT OF FINANCIAL LIBERALIZATION: On average, the total effect of capital market liberalization in Eastern Europe countries was a positive one

20. IV. EMPIRICAL ANALYSISb. 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%) – hasa 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%) – hasa 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.

21. IV. EMPIRICAL ANALYSISb. 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 regressionReal 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.

22. IV. EMPIRICAL ANALYSISb. 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

23. V. 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 • Furtherresearch: • Methodology improvement • Analysis of crises appeared in developed economies • Other determinants selection

24. VI. REFERENCES • Eichengreen, B. and C. Arteta (2000), „Banking Crises in Emerging Markets: Presumptions and Evidence”, Institute of Business and Economic Research • Davis, E. P. and D. Karim (2007), „ Comparing Early Warning Systems for Banking Crises”, Economics and Finance Working Paper No. 07 - 11, Brunel University • Bekaert, G. and C.R. Harvey (2003), „Does Financial Liberalization Spur Growth?”, Journal of Financial Economics • 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 • Ranciere, R., A. Tornell and F. Westermann (2003a), „Crises and Growth: A Re-Evaluation”, NBER Working Paper • (2006b), „Decomposing the Effects of Financial Liberalization: Crises vs. Growth”, Journal of Banking and Finance • (2007c) „Systemic Crises and Growth”, Quarterly Journal of Economics • Chinn, M. D. (2002), „The Measurement of Real Effective Exchange Rates: A Survey and Applications to East Asia” NBER Working Paper • Kaminsky, G. S. Lizondo and C.M. Reinhart (1998), „Leading Indicators of Currency Crisis”, IMF Staff Project • Braun, M. and C. Raddatz (2006), „Trade liberalization, Capital Account Liberalization and the Real Effects of Financial Development”, Journal of International Money and Finance • Li, K. and N.R. Prabhala (2005), „Self-Selection Models in Corporate Finance”, Robert H. Smith School Research Paper No. RHS 06 - 020 • Manning, A. (2004), „Instrumental Variables for Binary Treatments with Heterogeneous Treatment Effects: A Simple Exposition”,The Berkeley Electronic Press

25. VI. REFERENCES • Kaminski, G. and C. M Reinhart (1999), „The Twin Crises: The Causes of Banking and Balance-of-Payments Problems”, The American Economic Review • Ergungor, E. and J. B. Thomson (2005), „Systemic Banking Crises”,Federal Reserve Bank of Cleveland, Policy Discussion Paper • Bekaert, G., C. R. Harvey and C. T. Lundblad (2003), „Equity Market Liberalization in Emerging Markets”, Federal Reserve Bank of St. Louis • 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 • Goldstein, M., G. L. Kaminski and C. M. Reinhart (2000), „Assessing Financial Vulnerability”, pag. 11 – 32., Institute for International Economics • Bordo, M., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria (2000), „Is the crisis problem growing more severe?”, Blackwell Publishing Economic Policy • 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. • 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 • Durlauf, S. N. and D. T. Quah (1998), „The New Empirics of Economic Growth”, Handbook of Macroeconomics • Durlauf S. N., P. A. Johnson and J. R. W. Temple (2004), „Growth Econometrics”, Handbook of Economic Growth • Barro, R. J. and J. F. Ursua (2008), „Macroeconomic Crises Since 1870”, NBER Working Paper • Kaminski, G. L. and S. L. Schmukler (2003), „Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization”, NBER Working Paper No. 9787

26. VI. REFERENCES • Greene, W. (2002), „Convenient Estimators for the Panel Probit Model: Further Results”, Empirical Economics, Vol. 29, No. 1 • Martin, P. and H. Rey, (2005), "Globalization and Emerging Markets: With or without Crash", American Economic Review • Dell’Ariccia, G., and R. Marquez, (2004), “Information and Bank Credit Allocation.” Journal of Financial Economics • Demirguc-Kunt A and E. Detragiache, (1998), "Financial Liberalization and Financial Fragility," IMF Working Paper 98/83. • http://www.duke.edu/~charvey/country_risk/chronology/chronology_index.htm • http://www.centralbankmalta.com/ • http://www.cnb.cz/cnb/stat.arady_pkg.parametry_sestavy?p_csest=3000&p_ind=g&p_lang=en • http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1&lang=en • http://www.bankofestonia.info/frontpage/en/%20 • http://www.bank.lv/eng/main/all/statistics/bank_mon_stat/bmsq42006/ • http://english.mnb.hu/engine.aspx?page=mnben_statisztikai_idosorok&contentid=7822 • http://www.lb.lt/stat_pub/statbrowser.aspx?group=7273&lang=en • http://www.nbp.pl/ • http://www.nso.gov.mt/ • http://www.statistics.sk/webdata/english/index2_a.htm • http://www.nbs.sk/indexa.htm • http://www.bsi.si/iskalniki/letna_porocila_en.asp?mapaid=711 • http://www.bnro.ro • https://statistici.insse.ro/shop/ • http://ec.europa.eu/economy_finance/indicators/annual_macro_economic_database/ameco_en.htm • http://www.tcmb.gov.tr/yeni/eng/

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