Financial Markets Volatility and Performance in Emerging Markets (National Bureau of Economic Research Conference Report) - Hardcover

Edwards, Sebastian; Garcia, Marcio Gp

Hardcover

ISBN 10: 0226184951 ISBN 13: 9780226184951

Publisher: University of Chicago Press, 2008

Synopsis

Capital mobility is a double-edged sword for emerging economies, as governments must weigh the benefits of investment against the potential economic costs and political consequences of currency crises, devaluations, and instability. "Financial Markets Volatility and Performance in Emerging Markets" addresses the delicate balance between capital mobility and capital controls as developing countries navigate the convoluted global network of private investors, hedge funds, large corporations, and international institutions such as the International Monetary Fund.A group of experts here examine rapidly globalizing financial markets with regard to capital flows and crises, domestic credit, international financial integration, and economic policy. Featuring detailed analyses and cross-national comparisons of countries such as Brazil, Argentina, Uruguay, and Korea, this book will shape economists' and policy makers' understanding of the effectiveness of restrictions on capital mobility in the world's most fragile economies.

About this title

About the Author

Sebastian Edwards is the Henry Ford II Professor of International Business Economics at the Anderson Graduate School of Management at the University of California, Los Angeles. He is the author or editor of several books, including The Decline of Latin American Economies and Capital Flows and the Emerging Economies, both published by the University of Chicago Press. Marcio G. P. Garcia is associate professor of economics at Pontificia Universidade Catolica do Rio de Janeiro and a visiting associate professor at Stanford University's Center for Research on Economic Development and Policy Reform.

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Financial Markets Volatility and Performance in Emerging Markets

The University Of Chicago Press

Copyright İ 2008 National Bureau of Economic Research
All right reserved.
ISBN: 978-0-226-18495-1

Contents

Preface..................................................................................................................................................................................................................................ixIntroduction Sebastian Edwards and Mrcio G. P. Garcia..................................................................................................................................................................................11. Links between Trade and Finance: A Disaggregated Analysis Joshua Aizenman and Ilan Noy Comment: Maria Cristina Terra Comment: Thierry Verdier.....................................................................................92. Ineffective Controls on Capital Inflows under Sophisticated Financial Markets: Brazil in the Nineties Bernardo S. de M. Carvalho and Mrcio G. P. Garcia Comment: Gustavo H. B. Franco Comment: Marcelo Abreu.....................293. Financial Openness, Currency Crises, and Output Losses Sebastian Edwards Comment: Edmar L. Bacha Comment: Marcelo Kfoury Muinhos..................................................................................................974. Capital Market Development: Whither Latin America? Augusto de la Torre, Juan Carlos Gozzi, and Sergio L. Schmukler Comment: Ugo Panizza............................................................................................1215. Judicial Risk and Credit Market Performance: Micro Evidence from Brazilian Payroll Loans Ana Carla A. Costa and Joo M. P. De Mello Comment: Renato G. Flres Jr...................................................................1556. Liquidity Insurance in a Financially Dollarized Economy Eduardo Levy Yeyati Comment: Marco Bonomo Comment: Alejandro Werner.......................................................................................................1857. Sudden Stops and IMF-Supported Programs Barry Eichengreen, Poonam Gupta, and Ashoka Mody Comment: Ilan Goldfajn....................................................................................................................2198. Mutual Reinforcement: Economic Policy Reform and Financial Market Strength Anne O. Krueger..........................................................................................................................................267Contributors.............................................................................................................................................................................................................................279Author Index.............................................................................................................................................................................................................................281Subject Index............................................................................................................................................................................................................................285

Chapter One

Links between Trade and Finance: A Disaggregated Analysis

Joshua Aizenman and Ilan Noy

1.1 Introduction and Overview

Traditional analysis of open developing countries viewed trade and financial integrations as two independent margins of openness. Accordingly, trade integration deals with "real issues" related to export orientation versus import substitution, whereas financial integration deals with "financial issues" related to the degree to which the domestic capital market is segmented from foreign ones. Yet recent research suggests that the two margins of openness are interrelated in various hidden channels. Examples of these links include market pressures through, for example, the need for trade financing and political economy considerations that may have an impact both on trade flows and through that on the degree of financial repression.

The market pressure channel follows the logic of arbitrage-segmentation implies gaps across borders in relative prices or returns, providing profitable opportunities. Goods smuggling may be viewed as endogenous outcome of costly enforcement of commercial policy. Similarly, trade mis-invoicing may be viewed as an endogenous outcome of costly enforcement of financial segmentation, linking trade and financial integrations-in this case, greater trade openness will increase de facto financial openness (see Aizenman and Noy [2004] for further discussion).

A political economy channel is exemplified by Rajan and Zingales (2003), who propose an interest group theory of financial development whereby incumbents oppose financial development because it breeds competition. In these circumstances, the incumbents' opposition will be weaker when an economy allows both cross-border trade and capital flows. They predict that country's domestic financial development should be positively correlated with trade openness and identify the time varying nature of this association.

Other theoretical models that connect trade openness with financial factors also exist. Do and Levchenko (2004, 2006), for example, develop a two-sector trade model in which one sector is more financially intensive, and cross-border financial flows depend on the size of this sector. They conclude that in the country that uses this sector more intensively (the rich country), opening up to trade will result in more financial flows and a deeper financial system (the opposite is true for the other country). Rose and Spiegel (2004) develop a model of sovereign lending and suggest that if a credible threat to reductions in trade is what sustains sovereign lending, then one should observe more lending occurring between countries whose trade links are stronger. Petersen and Rajan (1997) focus on trade credits and investigate theoretically and empirically what firm characteristics will drive an increased usage of trade credits to finance trade transactions.

Most papers that do distinguish between different types of financial flows, however, do not investigate their impact on trade flows (e.g., Smith and Valderrama 2006). Several projects, though, focus on the theoretical links between foreign direct investment (FDI) and trade openness; Swenson (2004), for example, examines whether FDI and trade flows are complements or substitutes. She suggests a theory to support her findings of complementarities at a high level of data aggregation and substitution effects at the product level. Aizenman and Noy (2006), on the other hand, propose a theory of links that describe dynamic complementarities, both from FDI to trade and from trade to FDI.

A number of recent empirical papers have begun to examine the differences between the determinants of trade flows and financial flows. For example, Eaton and Tamura (1994) compare the determinants of Japanese and U.S. trade and foreign investment, while Guerin (2006) compares a gravity model for trade with similar gravity models for FDI and portfolio flows. Guerin (2006) builds on a growing literature that uses gravity models to empirically examine the determinants of financial flows focusing exclusively on FDI and portfolio flows (e.g., Portes, Rey, and Oh 2001; Razin, Rubinstein, and Sadka 2003; Wei 2000). Interestingly, these papers typically do not examine the links between the financial flows and trade flows but rather compare their determinants and find similar specifications fit both trade and financial flows. Another branch in this literature examines the joint effect of both financial and trade flows on a third variable as, for example, in Kose, Prasad, and Terrones (2006) investigation of their impact on output growth volatility. A different strand investigates and compares the determinants of different types of financial flows without investigating their relationship to trade flows (e.g., Daude and Fratzscher 2006). A recent survey of the literature on financial openness and its causes and effects is Kose et al. (2006).

In recent works we have looked at the degree to which the data is consistent with the presence of two-way feedbacks between trade and financial openness. We adopted a reduced form approach, where we tested the presence of two-way intertemporal linkages between trade and financial de facto openness. The results are reported in Aizenman and Noy (2004), where we confirm the presence of almost symmetric intertemporal feedbacks between trade and financial openness and in Aizenman and Noy (2006), where we report significant intertemporal feedbacks for FDI and goods trade. Following Bekaert, Harvey, and Lumsdaine's (2002) distinction between market liberalization (de jure) and market integration (de facto), we also found asymmetric importance of de jure measures of openness-trade policy has a robust effect on trade openness, but financial restrictions seem to have no significant impact on de facto financial openness.

This paper extends our previous analysis-having established the presence of strong two-way intertemporal feedbacks between trade and financial openness, we now examine the strength of the intertemporal feedbacks between disaggregated measures of trade and financial openness in developing countries. Specifically, we disaggregate the current account into trade in goods (split between manufacturing, metals/ores, fuel, and foodstuffs), services, and income. Similarly, we disaggregated the financial account into FDI, loans, equity, and trade credit. Such disaggregation provides us with more detailed information about the possible channels at work.

Among the interesting patterns we uncover, we observe systematic changes between the 1980s and the 1990s. Most financial flows in and out of developing countries have taken the form of loans. Yet these financial flows are the only type of flows that have decreased between the two decades. We thus see a growing importance to developing countries of portfolio flows and especially of FDI. The trade statistics do not present a clear temporal trend toward an increase from the 1980s to the 1990s. While services trade has increased, goods trade has seen a corresponding decrease. Once the information for trade in goods is disaggregated by type of good, we observe that manufacturing trade has increased dramatically, while trade in fuels has seen a dramatic decline as percent of domestic output. Investigating the patterns of the correlation coefficients between disaggregated financial openness measures and the trade openness measures reveals a significant correlation of FDI flow measures with goods and services trade and a very strong correlation between openness to trade in goods and trade in services.

Next, we looked at the impact of lagged disaggregated trade on disaggregated financial measures, allowing for macroeconomic controls. While past average trade in goods appears to be correlated with FDI and loan flows, this is not the case for the equity and trade credits measures. Trade in incomes is positively correlated with FDI, reflecting the repatriation of profits from foreign investments. Interestingly, and less expectedly, trade in services is negatively correlated with all the four measures of financial flows-while it is statistically significant only for the FDI and equity measures. For the subaccounts for goods trade, we observe that trade in foodstuffs is positive and statistically important for FDI flows, as is the measure for metals/ores trade. We conclude by tracing the reversed link-the impact of lagged disaggregated financial on disaggregated trade measures, allowing for the same macroeconomic controls. Interestingly, gross domestic product (GDP) per capita is negatively correlated with trade openness for goods and services (with the coefficient for goods trade three times as big as the one for services). We also observe a positive coefficient for the budget surplus, the inflation measure, the U.S. interest rate and the degree of democracy. In all those results, the control variables are more strongly associated with goods trade than with trade in services. Corruption is negatively and significantly associated with goods trade. Foreign direct investment openness is associated with trade openness, with the impact twice as large for goods trade than for trade in services. This impact is also much larger than the other various measures of financial openness (equity, loans, and trade credits). The coefficients on loan flows are negatively and typically statistically significant, while equity flows are positively associated only with goods trade. The measure of trade credits is never statistically significant. Section 1.2 describes the data, section 1.3 discusses the methodology and results in more detail, and section 1.4 concludes.

1.2 Data

We include all nondeveloped countries and territories for which all data are available in the 2001 edition of the World Bank's World Development Indicators. Most of the data on the financial subaccounts are typically available only from the early 1980s, while the political data we require is available only up to 1998. Our data set, therefore, covers the years 1982 to 1998.

Blonigen and Wang (2004), among others, argue that pooling developed and developing countries in empirical studies of this type is inappropriate and likely to lead to misleading results. In previous work, we also found that industrialized/developed countries appear to be different from developing countries as the nature of financial flows for these groups is different (Aizenman and Noy 2006). For example, FDI inflows into developed countries might be mostly of horizontal FDI, while those into developing countries might be of vertical FDI. We thus focus our empirical investigation on developing countries only.

The developed economies deleted from the set are those economies that were members of the Organization for Economic Cooperation and Development (OECD) in 1990. We also exclude island economies from our estimations as these are often used as offshore banking centers, and their level of de facto openness to financial flows is often dramatically different from other countries with similar income levels. The sixty countries included in the data set are Algeria, Argentina, Bangladesh, Belize, Bolivia, Botswana, Brazil, Cambodia, Cameroon, Chile, China, Colombia, Costa Rica, Ivory Coast, Ecuador, Egypt, El Salvador, Gabon, Gambia, Ghana, Guatemala, Guyana, Honduras, India, Indonesia, Israel, Jamaica, Jordan, Kenya, Korea, Malaysia, Mauritius, Mexico, Morocco, Mozambique, Nepal, Nicaragua, Nigeria, Pakistan, Panama, Papua New Guinea, Paraguay, Peru, the Philippines, Senegal, Sierra Leone, South Africa, Sri Lanka, Swaziland, Syria, Tanzania, Thailand, Togo, Tunisia, Turkey, Uganda, Uruguay, Venezuela, Zambia, and Zimbabwe. Our sample is further restricted by the availability of data for some years.

We measure gross financial flows (de facto financial openness) as the sum of total capital inflows and outflows (in absolute values) measured as a percent of GDP. Capital flows are the sum of FDI, portfolio flows, trade credits, and loans. We construct an openness index for each one of these four components and briefly describe them in the following. The data on financial flows is taken from the International Monetary Fund's (IMF's) Balance of Payments Statistics data set and are exactly analogous to the standard measure of commercial openness (sum of exports and imports as percent of GDP).

We subdivide the standard measure of commercial openness into openness for trade in goods, trade in services, and trade in incomes following the classification adopted by the World Bank. We further divide trade in goods into openness measures for trade in foodstuffs, in fuel, in manufacturing, and in metals/ores. This data is from the World Bank's World Development Indicators. We provide descriptive statistics in tables 1.1 to 1.3.

Table 1.1 presents averages for financial and trade openness for the 1980s and 1990s across geographical regions, while table 1.2 presents the financial and trade openness indexes disaggregated by type (FDI, loans, trade credits, and equity flows for the financial measures and goods, services, and incomes for the trade measures). A number of noteworthy observations are obtained from these tables, summarized in figure 1.1. First, the degree of financial and trade openness is universally larger during the 1990s than it was in the previous decade, although the degree of difference differs substantially across geographical regions. The OECD countries and the countries of East Asia were the most open to financial flows, and the least financially open groups are sub-Saharan Africa, the Middle East and North Africa (MENA) countries, and South Asia.

Secondly, when financial openness is disaggregated by type, we observe that most financial flows in and out of developing countries have taken the form of loans. Yet these financial flows are the only type of flows that have decreased between the two decades. We thus see a growing importance to developing countries and portfolio flows and especially of FDI. The trade statistics do not present a clear temporal trend toward an increase from the 1980s to the 1990s. While services trade has increased (from about 21 percent to 23 percent of GDP), goods trade has seen a corresponding decrease (from about 66 percent to 62 percent). Once the information for trade in goods is disaggregated by type of good, we observe that manufacturing trade has increased dramatically (from 29 percent to 39 percent), while trade in fuels has seen a dramatic decline (from 24 percent to 10 percent of GDP).

Table 1.3 presents correlation coefficients between the financial openness measures and the trade openness measures disaggregated by types of flows. The notable correlations are a significant correlation of FDI flow measures with goods and services trade (0.60 and 0.55, respectively) and a very strong correlation between openness to trade in goods and trade in services (0.87).

Because results from all the estimation procedures described in the following will be biased if any of the relevant series has a unit root, we are also required to establish stationarity. We conduct the common Phillips-Perron (1981) test for unit roots for the financial openness variables as well as the trade openness measures. Results are presented in table 1.4. We easily reject the existence of unit root in all cases. In our multivariate estimations, we include several control variables that are described in the following. This list is based on our previous research on financial openness (Aizenman and Noy 2004). In order to ensure our results are not driven by a 'missing variables' bias, we include a host of macroeconomic control variables. In all regressions we use per capita GDP (measured in PPP dollars), a domestic interest rate spread (from a world rate of interest), and a weighted average of G3 growth rates. In an initial specification, we also included the government's budget surplus (as percent of GDP), the inflation rate (CPI), a world interest rate (U.S. one-year T-bill rate), GDP (in $1995), and government consumption (as percent of GDP). None of these were significant, and all were dropped from the specifications we report. The macroeconomic data are taken from the World Bank's World Development Indicators and the International Monetary Fund's International Finance Statistics. Details are in the appendix.

(Continues...)

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Edition details

• Publisher: University of Chicago Press
• Publication date: 2008
• Language: English
• ISBN 10: 0226184951
• ISBN 13: 9780226184951
• Binding: Hardcover
• Number of pages: 304