Endogenous Financial and Trade Openness: Efficiency and Political Economy Considerations NBER working papers #10144, 1

1. Endogenous Financial and Trade Openness: Efficiency and Political Economy ConsiderationsNBER working papers #10144, 10496 Joshua Aizenman University of California Santa Cruz Ilan Noy University of Hawaii Manoa

2. The Purpose • Studying the endogenous determination of financial openness • Two benchmark models of financial openness: • Public finance, representative agent • Opportunistic policymaker, facing political uncertainty • Empirical work • Decomposing the linkages between financial and trade openness • Identifying the determinants of financial openness

3. TRADE OPENNESS (t)…(t+2) FINANCIAL OPENNESS (t+1) Higher trade openness reduces optimal financial repression Higher vertical FDI increases international trade, cheaper trade credits, etc.

4. De-facto Financial Openness Most studies focused on the formal acts associated with de-jure financial opening. De-facto financial integration is of independent and considerable interest. • Prasad et. al. (2003), Wei and Wu (2003) The de-facto level of financial openness is the outcome of the interaction between: • de-jure financial openness • enforcement • market forces

5. The public finance model • The policy maker problem: • how to fund given G relying on income tax and on financial repression. • Costly taxes: • income tax is associated with collection costs; • financial repression is associated with expenditure on monitoring and policing. • The consumer’s problem: • capital flight (with risk of appropriation) or domestic bonds (income taxed).

6. Results: The public finance model • Financial repression is optimal below a threshold of fiscal efficiency • Higher cost of tax collection, higher fiscal expenditure and lower commercial openness would increase the “optimal” financial repression. • Cukierman, et al. (1992): functioning democracies and less polarized societies tend to have more efficient tax collection systems, hence tend to be associated with lower taxes and lower capital flight.

7. The opportunistic model • The policy maker controls the income from exporting a natural resource, and faces an uncertain future horizon. • Second period output is determined by first period investment (financed by the policy maker, or by outside parties). • The policy maker chooses between investing (and producing output in the second period) or moving the income offshore (where it will be consumed by the policymaker).

8. Results: The opportunistic model • Higher probability of regime change  • First-period policy maker increases offshore saving and reduces investment. • increases the investment financed by the outside party. • Higher probability of regime change would increase both capital flight and capital inflow  higher de-facto financial openness.

9. Empirical methodology • Determinants of financial openness: • Macro controls: vector X • Average lagged commercial openness – • Political economy controls: vector P • Estimation using the Prais-Winsten procedure: • A two-step FGLS using the estimated correlation coefficient obtained from a first-step OLS regression (from the DW statistic). • Reverse specification for trade openness • Decomposition of causality

10. Financial Openness(percent of GDP)

11. Overview of results: Empirics I • De-facto financial openness (FO) depends… • positively on lagged trade openness and GDP/Capita. • negatively on the budget surplus for developing countries (positive for the OECD). • negatively on corruption. • A more openly competitive, democratic, free, and inclusive political system is associated with lower FO . (The effect is more significant once we control for corruption).

12. Overview of results: Empirics II • For developing countries, a one s.d. increase in… • commercial openness increases FO By 9.5%, • the democracy index reduces FO by 3.5%, • corruption index reduces FO by 3%. • Reverse causality from financial to trade openness is also quantitatively important. • Decomposition of links between financial and trade openness (Geweke decomposition)

13. For future research • Disaggregate de-facto financial openness, and de-facto trade openness into their various components. • A more direct empirical investigation into some of our hypotheses is called for: • direct measures of tax collection efficiency (for different tax instruments). • a more direct measure (or a better proxy) for political uncertainty. • Bi-lateral data-set for financial flows