Financial integration and economic performance of the SACU countries: do different types of capital stocks matter?

1. Financial integration and economic performance of the SACU countries: do different types of capital stocks matter? By Prof. Meshach Aziakpono Department of Economics, Rhodes University Prof. Philippe Burger Department of Economics, University of Free State And Prof. Stan du Plessis Department of Economics, University of Stellenbosch Paper for presentation at the 16th Annual Conference of the Southern African Finance Association (SAFA), January 14-16, 2009

2. Outline of Presentation • Introduction • Objective of the Study • Definition and measurement of FI • Theoretical Framework • Empirical Literature • Methodology • Data • Results • Conclusion

3. 1. Introduction • Increasing integration of financial markets across international borders is a remarkable feature of the last two decades. • Long history of official integration arrangement among SACU countries

4. 2. Objective of study • To provides evidence on the FI-growth nexus based on the experience of the SACU countries. Specifically: • To examine the nature (i.e. the sign and size) of the effects of FI on the level of per capita income in each of the SACU countries. As a corollary, to explore the effect of economic performance on FI in SACU. • To explore the direction of causality between the level of income per capita and FI in each of the SACU countries. • To investigate the relative effects of the different types of capital stock on economic performance in the SACU countries. • To explore the channels through which FI affects economic performance of each of the economies. • Lastly, to determine whether or not the results of the above analysis are robust to controlling for other possible determinants of economic performance and FI.

5. 3.Definition and measurement of FI-1 • Definition • Economic literature does not offer a unique definition of financial integration • Terms such as financial openness, external financial liberalisation, financial globalisation and capital account liberalisation have also been used in connection to financial integration • De jure (prerequisites for financial integration) • Removal of any administrative and market-based restrictions on capital movement across borders • Removal of regulatory, legal and tax discrimination between foreign and domestic suppliers of financial services • Existence of a transparent and efficient legal system and quality law enforcement • De facto financial integration (integration outcomes) • Relates to price- or return on assets, capital flows, household decisions, and corporate policy

6. Figure 1: Framework for Categorising Measures of Financial Integration

7. 4. Theoretical Framework: Role of FD

8. 4.Theoretical Framework: Role of FI

9. 4.Theoretical Framework: Channels of FI • Direct channel • through increasing domestic investment by augmenting domestic saving and reducing the cost of capital • Because of international risk sharing • Indirect channels • simulation of domestic financial sector development, • transfer of technology and managerial know-how, • macroeconomic discipline and • signaling effect

10. 4.Theoretical Framework: Potential costs of FI • Potential costs: • geographical concentration of capital flows • lack of access to such capital flows by small countries, • domestic misallocation of capital flows, • loss of macroeconomic stability, • pro-cyclicality of short-term flows, • volatility of capital flows and • risk of entry by foreign banks.

11. 5. Empirical Literature-1 • The burgeoning and increasingly innovative empirical literature provides conflicting evidence on the effects of IFI on economic growth and welfare • From a methodology perspective studies range from: • the use of simple ordinary least squares (OLS) cross-sectional regression analyses (cf. Klein, 2003; Arteta et al. 2001; Edwards, 2001; Klein and Olivei, 1999; Kraay, 1998; Rodrik, 1998; Quinn, 1997), • advanced dynamic panel estimation techniques that control for potential biases in the earlier methods (cf. Kim et al. 2005; Laureti and Postiglione, 2005; Calderon et al. 2004; Edison et al. 2002; Reisen and Soto, 2001) • time series studies that employ the vector autoregressive (VAR) model (cf. Jin 2006; Kim et al. 2004).

12. 5. Empirical Literature-2 • Recent studies have examined a range of other issues in addition to investigating the standard question of whether or not FI really promotes economic growth. These include: • the conditions under which FI contributes to economic growth, e.g. • institutional quality (cf. Klein, 2005, Edison et al. 2004; Edison et al. 2002), • level of per capita income (cf. Klein, 2007; 2003; Edison et al. 2004; Edison, et al. 2002), • ethnic and linguistic heterogeneity (cf. Chanda, 2005); • whether the effects of FI differ during different eras of financial globalisation (cf. Schularick and Steger 2007; 2006) • whether the effects of FI depend on the type of capital inflows (cf. Laureti and Postiglione, 2005; Collins, 2004); and • the sources of effects of integration (cf. Schularick and Steger, 2007; Collins, 2004).

13. 5. Empirical Literature-3 • Authoritative surveys of the literature by other authors, such as Kose et al. (2006), Collins (2004), Edison et al. (2004) and Prasad et al. (2004) found mixed evidence. • For instance, Kose et al. (2006) found that most of the studies obtain no effect or the results were ambiguous (results that are not robust across alternative specifications) for developing countries. • Hence, they concluded that “…if financial integration has a positive effect on growth, it is apparently not robust, once the usual determinants of growth are controlled for” (p.13).

14. 5. Empirical Literature-4 • An analysis of many of the previous studies on the effects of FI on growth reveals that the mixed results reflect differences across the studies: • the measures of FI used, • country sample, • time period cover, • econometric methodology, and • the set of control variables used.

15. 5. Empirical Literature-5 • A major weakness of most previous studies relates to the frameworks used, such as the cross-sectional and panel data approaches: • the inability of the approaches to cater adequately for the endogeneity of FI and some of the right-hand side variables; • hence they cannot be used to establish causal relation between economic growth and such variables. • the coefficient estimates are only average effects for a sample of countries covered and do not represent any particular country in the sample. This makes it difficult to draw country-specific policies conclusions based on such results.

16. 6. Methodology-1 • To achieve the above objectives, the analysis in this study draws on previous studies in a number of ways: • First, following the trend in recent literature (IMF, 2007; Collins, 2004; O’Donnell, 2001; Reisen and Soto, 2001; Kraay, 1998), the current analysis employs different de facto measures of FI as opposed to the de jure measures. • Second, it uses the standard control variables used in growth literature. • It departs from most of the previous studies that use cross-sectional and panel data approaches by adopting a time-series country-specific approach. • Hence, it is similar to Kim et al. (2004) and Jin (2006). But, unlike the Kim et al. (2004) and Jin (2006) studies, the current study explicitly explores the endogeneity of each of the variables used as well as models the long-run causality between FI and per capita income • Moreover, it focuses on SACU countries

17. 6. Methodology-2 • The study adopts a trivariate cointegration and error correction modelling technique based on the Johansen maximum likelihood approach • Model: (4) • where, LPY, FI and CV represent the level of per capita income, FI and a control variable. • Unit root test: DF-GLS and Ng and Peron 2001 • Cointegration test • weak exogeneity test (causality test)

18. 6. Methodology-3 • Due to the low degree of freedom due to the small sample size, the study follows Kim et al. (2004:630) in including only three variables in each model (i.e. a trivariate model). • By sequentially adding and subtracting a control variable, it is possible to test the robustness of the long-run relationship obtained in the models, i.e. whether or not the long-run effect is dependent on the control variables • The quality of models where cointegration is found and the variable of interest (LPY or FI) is endogenous in the mode is evaluated using two criteria: • First, must pass the residual diagnostic tests – serial correlation and heteroskedasticity tests • Second, a threshold of 30% explanatory power (the adjusted R2) for any model to be reported for analysis

19. 6. Methodology: Econometric procedure-1

20. 6. Methodology: Econometric procedure-2

21. 6. Methodology: Econometric procedure-3

22. 7. Data • In line with standard practice in most time-series studies (cf. Demetriades and Hussein, 1996; Arestis and Demetriades, 1997; Luintel and Khan, 1999) this study uses the level of per capita real GDP as a measure of economic performance • We four measures of IFI:LFDIL, LDL, LFIA and LFIL • We use as control variable: • Two measures of financial development (LFDC and LFDL) • the ratio of domestic investment to GDP (INV), • the ratio of government expenditure to GDP (GE), • inflation rate (INF), • trade openness measured as the ratio of sum of export plus import to GDP (OPN) • Data covers the period 1970 to 2004, although, for many series, data was not available for the entire period. The series ranges from 29 to 34 continuous annual observations • Sources: dataset on External Wealth of Nations Mark II by Lane and Milesi-Ferretti (2006), IMF IFS 2007 CD-ROM , World Bank World Indicators

23. 8. Results • Altogether, the study estimates 25 models each for Botswana, South Africa and Swaziland. Due to data limitation, the study estimates only ten models for Lesotho. • Of the 25 models estimated, a stable long-run relationship is found in 18 in Botswana, 13 in South Africa and 5 in Swaziland. In Lesotho, 7 of the 10 models estimated produce a stable long-run relationship.

24. Botswana-1

25. Lesotho-1

26. South Africa-1

27. Swaziland-1

28. Botswana-2

29. Lesotho-2

30. South Africa-2

31. Swaziland-2

32. 8. Results: Botswana • To summarise the results of the analysis for Botswana, • Overall the results do not produce robust evidence on the effect of FI on output: • The evidence does not support the contention that the stock of FDI has a stronger positive effect on economic growth than the stock of debt. • The results suggest that FI affect the level of output through both the direct channel (investment channel) and indirect channels such as through domestic financial system development. • But such direct and indirect effects of FI on output level appear to be negative in Botswana.

33. 7. Results: Lesotho • In summary, the results highlight a number of key findings for Lesotho: • Overall, the results suggest that an accumulation of foreign liability of banks causes an increase in the level of per capita income. But the effect is not conclusive if banks accumulate foreign assets. • The evidence suggest that FI affects the level of income through both the direct channel (investment channel) and the indirect channels, but while the direct channel appears to have a positive effect, the indirect channel through deposit market development has a negative effect

34. 7. Results: South Africa • In summary, the following are the key findings for South Africa. • Overall, the effect of FI on output depends on the types of stock of capital. Whereas, the FDI-related capital cause output to increase, the debt related flows have a negative effect on output, thereby supporting the view that FDI inflows are better than debt inflows in promoting economic growth in South Africa. • The results suggest that FI operates through both the direct and indirect channels, with the investment channel having a strong positive effect on the level of output in South Africa. • The results also suggest that FI operates through other indirect channels, such as domestic institutional development, signalling effect, with such channels appearing to have positive effect on output in South Africa.

35. 7. Results: Swaziland • In summary, the weight of evidence strongly suggests a positive effect of FI on output levels in Swaziland. • Notably, the positive effect stems from the accumulation of debt-based capital stocks, while FDI inflows has a negative effect in Swaziland. • Financial integration seems to operate through both the direct and the indirect channels. • Also the result suggests that an increase in the level of income leads to an increase in the degree of FI, specifically accumulation of bank foreign assets.

36. 8. Conclusion • The effects of FI on the output level, the results are mixed; the effects vary from country to country and depend on the types of capital stock. • The effect of FDI is negative in Botswana, positive in South Africa but ambiguous in Swaziland. • The stock of debt liabilities has a negative effect in Botswana and South Africa while the effect is positive in Swaziland. • The ratio of foreign assets of banks has an ambiguous effect in Botswana, Lesotho and South Africa while no effect was detected in Swaziland. • Lastly, the ratio of foreign liabilities of banks has a positive effect in Lesotho and Swaziland and a negative effect in South Africa, while the effect is ambiguous in Botswana.