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

THE EFFECT OF CAPITAL THE EFFECT OF CAPITAL MARKET LIBERALIZATION MARKET LIBERALIZATION IN EASTERN EUROPE: IN EASTERN EUROPE:

ECONOMIC GROWTH OR ECONOMIC GROWTH OR FINANCIAL CRISISFINANCIAL CRISIS

MSc Student: LAVINIA CRISTESCUCoordinator: PhD. Professor MOISĂ ALTĂR

Bucharest, July 2008

- Dissertation Paper -

Academy For Economic Studies, Bucharest - Doctoral School of Finance and Banking (DOFIN)

CONTENTSCONTENTS

I. Introduction

II. Literature Review

III. Model Specifications

IV. Empirical Analysisa. The Data

b. Testing The Financial Liberalization Effect

V. Conclusions

VI. References

I. INTRODUCTIONI. INTRODUCTION

FINANCIAL LIBERALIZATION

OF EQUITY MARKETS

Openes international financing path

Decreases the cost of capital

Increases investment

Leads to a more rapid economic growth

Also, may lead to:

A decline in credit’s portfolio quality

An increase in financial fragility

Macroeconomic volatility to external shocks

FINANCIAL CRISES AND LOSSES

Positi

ve ef

fects

Negative effects

II. LITERATURE REVIEWII. 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.

III. MODEL SPECIFICATIONSIII. 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.

CRISIS MODEL (Panel, probit)


1 if W*i,t > 0Ii,t = 0 otherwise.

W*i,t = aZi,t + bFLi,t + ηi,t

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)

W*i,t is 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

Two step estimation procedure

(Maddala (1983))


GROWTH MODEL

CRISIS MODELTREATMENT 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)


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:

θ(ae Zi,t + be FLi,t) / Φ(ae Zi,t + be FLi,t), if Ii,t = 1hi,t =

- θ(ae Zi,t + be FLi,t) / [1 - Φ(ae Zi,t + be FLi,t)], if Ii,t = 0

Φ = cumulative distribution function of a standard normal

θ = probability density of a standard normal

ASSUMPTION: the errors are bivariate normal, but not independent


TOTAL AVERAGE CAUSAL EFFECT OF FINANCIAL LIBERALIZATION

Due to a change in the financial liberalization dummy from 0 to 1

E(yi,t | FLi,t = 1) - E(yi,t | FLi,t = 0) = βe + γe E[Φ(aeZi,t + be) – Φ(aeZi,t)]

Financial Liberalization Direct Effect Indirect Effect Total Effect

IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISa. The Dataa. 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

NO. COUNTRYFINANCIAL

LIBERALIZATION YEAR

BANKING CRISIS YEAR

CURRENCY CRISIS YEAR

FINANCIAL CRISIS

EU MEMBER FROM

1 BULGARIA*,c 1998 1995, 1996 1995 1995, 1997 2007

2 CYPRUS 2004 2004

3 CZECH REPUBLIK,c 1994 1997 1997 1997 2004

4 ESTONIA,c 1996 2004

5 HUNGARY*,c 1996 1995 1995 2004

6 LATVIA*,c 1996 1995 1995 2004

7 LITHUANIA,c 1996 1995, 1996 1995, 1996 2004

8 MALTA* 2004 1997 1997 2004

9 POLAND,c 1995 2004

10 ROMANIA,c 1997 2000 2000 2007

11 SLOVAKIA, c 1996 1998 1998 2004

12 SLOVENIA, c 1994 2004

13 TURKEY 1989 2000 2000 -


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


PROBIT DEPENDENT VARIABLE: Ii,t through the unobserved, latent variable W*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

IV. EMPIRICAL ANALYSISIV. EMPIRICAL ANALYSISb. Testing The Effect of Financial Liberalizationb. Testing The Effect of Financial Liberalization

TREATMENT EFFECT MODEL TWO STEPS ESTIMATION (STATA 9.1.)


THE ESTIMATORS’ CONFIDENCE LEVEL:

All the regressions’ coefficients are significant for a 95% level of confidence


TESTING THE PROBIT RESIDUALS: Distribution:

The probit residual is not normally distributed


Correlograms:

There is no evidence of serial residual correlation

There is no serial correlation of residuals squared


TESTING THE GROWTH REGRESSION RESIDUALS

Histogram Correlogram

The growth residuals are not normally distributed.

The growth residuals are not autocorrelated


TESTING THE GROWTH AND PROBIT RESIDUALS’ DEPENDENCE

εi,t = Ci,t + ηi,t + ei,t

New linear regression:

There is a dependence between the growth and the probit residuals

=> The two residual series are not normally bivariate and are not independent


TOTAL AVERAGE EFFECT OF FINANCIAL LIBERALIZATION:

DIRECT EFFECT βe 0.2197727

INDIRECT EFFECT γe E[Φ(aeZi,t + be) – Φ(aeZi,t)] 2.10817E-19

TOTAL EFFECT βe+ γe E[Φ(aeZi,t + be) – Φ(aeZi,t)] 0.2197727

On average, the total effect of capital market liberalization in Eastern Europe countries was a positive one


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%) – has a 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%) – has a 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.


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 regression Real 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.


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

V. CONCLUSIONSV. 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

Further research:

Methodology improvement

Analysis of crises appeared in developed economies

Other determinants selection

VI. REFERENCESVI. REFERENCES1. Eichengreen, B. and C. Arteta (2000), „Banking Crises in Emerging Markets: Presumptions and

Evidence”, Institute of Business and Economic Research

2. Davis, E. P. and D. Karim (2007), „ Comparing Early Warning Systems for Banking Crises”, Economics and Finance Working Paper No. 07 - 11, Brunel University

3. Bekaert, G. and C.R. Harvey (2003), „Does Financial Liberalization Spur Growth?”, Journal of Financial Economics

4. 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

5. Ranciere, R., A. Tornell and F. Westermann (2003a), „Crises and Growth: A Re-Evaluation”, NBER Working Paper

6. (2006b), „Decomposing the Effects of Financial Liberalization: Crises vs. Growth”, Journal of Banking and Finance

7. (2007c) „Systemic Crises and Growth”, Quarterly Journal of Economics

8. Chinn, M. D. (2002), „The Measurement of Real Effective Exchange Rates: A Survey and Applications to East Asia” NBER Working Paper

9. Kaminsky, G. S. Lizondo and C.M. Reinhart (1998), „Leading Indicators of Currency Crisis”, IMF Staff Project

10. Braun, M. and C. Raddatz (2006), „Trade liberalization, Capital Account Liberalization and the Real Effects of Financial Development”, Journal of International Money and Finance

11. Li, K. and N.R. Prabhala (2005), „Self-Selection Models in Corporate Finance”, Robert H. Smith School Research Paper No. RHS 06 - 020

12. Manning, A. (2004), „Instrumental Variables for Binary Treatments with Heterogeneous Treatment Effects: A Simple Exposition”, The Berkeley Electronic Press

VI. REFERENCESVI. REFERENCES13. Kaminski, G. and C. M Reinhart (1999), „The Twin Crises: The Causes of Banking and Balance-of-Payments

Problems”, The American Economic Review

14. Ergungor, E. and J. B. Thomson (2005), „Systemic Banking Crises”, Federal Reserve Bank of Cleveland, Policy Discussion Paper

15. Bekaert, G., C. R. Harvey and C. T. Lundblad (2003), „Equity Market Liberalization in Emerging Markets”, Federal Reserve Bank of St. Louis

16. 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

17. Goldstein, M., G. L. Kaminski and C. M. Reinhart (2000), „Assessing Financial Vulnerability”, pag. 11 – 32., Institute for International Economics

18. Bordo, M., B. Eichengreen, D. Klingebiel and M.S. Martinez-Peria (2000), „Is the crisis problem growing more severe?”, Blackwell Publishing Economic Policy

19. 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.

20. 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

21. Durlauf, S. N. and D. T. Quah (1998), „The New Empirics of Economic Growth”, Handbook of Macroeconomics

22. Durlauf S. N., P. A. Johnson and J. R. W. Temple (2004), „Growth Econometrics”, Handbook of Economic Growth

23. Barro, R. J. and J. F. Ursua (2008), „Macroeconomic Crises Since 1870”, NBER Working Paper

24. Kaminski, G. L. and S. L. Schmukler (2003), „Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization”, NBER Working Paper No. 9787

VI. REFERENCESVI. REFERENCES25. Greene, W. (2002), „Convenient Estimators for the Panel Probit Model: Further Results”, Empirical

Economics, Vol. 29, No. 126. Martin, P. and H. Rey, (2005), "Globalization and Emerging Markets: With or without Crash", American

Economic Review27. Dell’Ariccia, G., and R. Marquez, (2004), “Information and Bank Credit Allocation.” Journal of Financial

Economics28. Demirguc-Kunt A and E. Detragiache, (1998), "Financial Liberalization and Financial Fragility," IMF

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