Does Capital Account Liberalization Spur Economic and Financial Performance? New Investigation for MENA Countries Bassem

1. Does Capital Account Liberalization Spur Economic and Financial Performance? New Investigation for MENA Countries Bassem Kamar gefic@monaco.mc Femise AnnualConference Marseille 15-16 December 2011

2. Does Capital Account Liberalization Spur Economic and Financial Performance? New Investigation for MENA Countries • By • Mondher Cherif, ESC Sfax • (Tunisia) • Samy Ben Naceur - ESSEC Tunis • (Tunisia), • Mohamed Goaied - Université du 7 novembre à Carthage (Tunisia), • Bassem Kamar - International University of Monaco (Monaco) Bassem Kamar www.gefic.mc

3. Introduction • The debate on the benefits of capital account liberalization is still unsettled. • On one side, the “Washington consensus”, led by the IMF, claim that capital account liberalization can provide a more efficient allocation of resources, give wider possibilities for risk diversification, and spur financial development (Fisher 1998) • On the other side, many economists (Desai 2003, Stiglitz 2000, 2002 and 2004, Wade 1999, Veneroso 1998) accuse the IMF of encouraging developing countries to liberalize their capital account prematurely, which is a reason for their economic crises. Bassem Kamar www.gefic.mc

4. Introduction • Empirically, there is little evidence that capital account liberalization enhances growth • What have been found by Gourinchas and Jeanne (2002), McKinnon and Phill (1997, 1999) and Eicher and Turnovsky (1999) can be expressed as short –run “gains” and medium to long-run “pain”. • Recently, the IMF Chief Economist,Olivier Blanchard, published a series of papers in favor of some capital control in emerging markets, especially within the actual global crisis where capital inflows to these countries can be more “harmful than helpful” Bassem Kamar www.gefic.mc

5. Introduction • Therefore, we decided to investigate the impact of capital account liberalization on the economic performance in the MENA region • We look at the economic performance from different angles: • Growth • Competitiveness • FDI • Financial sector development Bassem Kamar www.gefic.mc

6. Literature review Impact on Growth • Requires a developed financial system and well functioning institutions Bassem Kamar www.gefic.mc

7. Literature reviewImpact on Competitiveness • Capital flows induced by capital account liberalization are an important determinant of the possible loss of competitiveness. The Salter (1959), Swan (1960), Corden (1960) and Dornbusch (1974) paradigm serves as the theoretical underpinning to test empirically the incidence of capital flows on the REER in emerging economies, as the model explains how a surge in capital flows would generate an appreciation of the REER (Corbo and Fisher, 1995) and a loss of competitiveness. • Nevertheless, Bakardzhieva at al. (IMF WP, 2010 and World Development 2012, FEMISE project) have demonstrated that not all capital flows lead to the appreciation of the REER as the outcome depends on how the inflows are spent. For example, if FDI inflows are spent on imported goods, perhaps they will not lead to REER appreciation. The authors also demonstrated that the impact of each capital flow varies across regions. Bassem Kamar www.gefic.mc

8. Literature reviewImpact on FDI • Desai, Foley, and Hines (2004): capital controls make operations more costly to the foreign affiliate, and thereby reduce FDI inflows significantly • Asied and Lien (2004): the impact varies by region, and has changed over time. In the 1970s and 1980s, no significant impact on FDI. In the 1990s, it becomes significant. Furthermore, capital controls have no effect on FDI to Sub-Saharan Africa and the Middle East, but affect FDI to East Asia and Latin America adversely. • Noyand Vu (2007): the liberalization of capital account is affected by the institutional factors - corruption and political stability, and is only efficient in generating more FDI inflows in an environment of low political risk. Bassem Kamar www.gefic.mc

9. Literature review Financial sector development • Positive impact of Capital account liberalization on Financial Development in most research • Klein and Olivei (2005): Concentrated among OECD because these countries enjoy better institutional and macroeconomic environments. • Chinn and Ito (2002): Financial systems with higher degree of institutional development benefit more on average from financial liberalization. • Baltagi et al. (2009): Capital account openness is a statistically significant determinant of banking sector development. Bassem Kamar www.gefic.mc

10. Methodology • 1- Capital account liberalization indicators • We use alternatively the following two indicators • IMFB: IMF’s indicator on the Annual Report on Exchange Arrangements and Exchange Restriction (AREAR) is a binary variable and doesn’t account for the different degrees of capital restrictions. • KAOPEN: Developed by Chinn and Ito (2006) and based on 4 indicators - multiple exchange rates, current account, and surrender of exports proceeds; and the five-year average of “controls on capital transactions” (SHARE). Bassem Kamar www.gefic.mc

11. KAOPEN in South Mediterranean Countries Bassem Kamar www.gefic.mc

12. KAOPEN in East Mediterranean Countries Bassem Kamar www.gefic.mc

13. KAOPEN in the GCC Bassem Kamar www.gefic.mc

14. Methodology • We use the Dynamic Panel System GMM estimator proposed by Arellano and Bover (1995) andBlundell and Bond (1998), over the period 1984-2008. • The advantage of using this estimator is that it accounts for the persistence of the dependent variables and for endogeneityissues. • We systematically test the validity of our results using the Sargan test and the test for serial correlation of the error term. Bassem Kamar www.gefic.mc

15. Dependent Variables • We estimate two different equations for each dependent variable below (one with each capital account liberalization measure) • GROWTH = real per capita GDP growth • REER = real effective exchange rate • FDI = foreign direct investment to GDP • Financial development: CPS = log of credit to the private sector (% of GDP); and LIQ = liquid liabilities of the financial system Bassem Kamar www.gefic.mc

16. Control Variables • Initial income (RGDPG) = log of real per capita GDP in the initial year • Financial development: CPS = log of credit to the private sector (% of GDP); and LIQ = liquid liabilities of the financial system • Inflation (INF) = the growth rate of consumer price index. • Trade Openness(TO) = share of exports and imports to GDP. • Government Consumption (GC)= government wages bills and supplies and services (source = WDI). • Institutional development (INST) = measures ofcorruption (CORR) and bureaucratic quality (BURQ) (source Country Risk Guide) • BANKCURR = banking and currency crises Bassem Kamar www.gefic.mc

17. Empirical Results - Capital Openness and Growth

18. Empirical Results - Capital Openness and Growth - 2

19. Interpretation of results - Capital Openness and Growth • Capital account liberalization strongly contributed to enhancing growth in MENA. This positive impact can be explained by the fact that the majority of MENA countries adopted partial capital account liberalization as explained by Ben Gamra (2009). • Trade openness also has the expected positive impact. • Government consumption has a negative impact on growth, which might be due to crowding-out of private sector investments. • Banking and currency crises also have the expected negative impact. Bassem Kamar www.gefic.mc

20. Empirical Results - Capital Openness and Competitiveness

21. Interpretation of results - Capital Openness and Competitiveness • Capital account liberalization has the expected significant negative impact on competitiveness (Dutch Disease) • Currency crisis leads to the depreciation of REER and enhances competitiveness • Government consumption has the same impact (tradable goods spending) • Income harms competitiveness (if spending is biased towards non-tradables) • Liquidity has no impact. Bassem Kamar www.gefic.mc

22. Empirical Results - Capital Openness and FDI

23. Interpretation of results - Capital Openness and FDI • Capital account liberalization has a significant positive impact on FDI. FDI usually look for financing possibilities on the world market, so liberalizing the capital account will allow them to borrow freely and more efficiently from foreign financial institutions. • Credit to private sector has a positive effect on FDI too – signal for healthy economy or possible source of financing for enlarging the activities in the host economy. Bassem Kamar www.gefic.mc

24. Interpretation of results - Capital Openness and FDI • Inflation: FDI favors a stable macroeconomic environment • Government consumption: sign of potential budget deficit and needs for financing through higher taxes, which is negative for profitability. • Bureaucracy: It is clear that less bureaucracy and the improvement of the business environment will attract more FDI • REER(very limited effect): the appreciation of REER leads to a loss of competitiveness and reduces the attractivity of the economy. Bassem Kamar www.gefic.mc

25. Capital Openness and Financial Development

26. Capital Openness and Financial Development

27. Interpretation of results - Capital Openness and Financial Development • Capital account liberalization has a significant positive impact on financial development. • Inflationhas a robust significant negative impact on financial development in all four models, which is in line with the findings of Boyd, Levine and Smith (2000). The explanation is that inflation interferes with the ability of the financial sector to allocate resources efficiently. • Incomeis significant and negative in three specifications out of four (non significant when used with credit to private sector and KAOPEN), but this result is counter intuitive and contradicts the endogenous growth theory and the work of Levine and Zervos (1996). Bassem Kamar www.gefic.mc

28. Interpretation of results - Capital Openness and Financial Development • Banking crisis is significant in the specifications where the dependent variable is credit to private sector, but not when using liquidity. The explanation could be that liquidity is managed by the central bank as a monetary policy tool, especially in times of crisis, and therefore might not be the optimal proxy to reflect the financial sector development; while credit to private sector is more probable to be affected by a currency or banking crisis as this type of crisis affects the capacity of banks to give credit. Bassem Kamar www.gefic.mc

29. Interpretation of results - Capital Openness and Financial Development • Trade openness is only significant in one specification which is when the dependent variable is liquidity, and non-significant elsewhere. This result is supported by the findings of Ito (2005) where he explains that trade openness is a prerequisite to enhance the positive impact of capital account liberalization on financial development. • Bureaucracyhas no significant impact on financial development except when used with credit to private sector and IMFB. In this particular case, the relation is positive, suggesting that an improvement in bureaucracy is sustaining financial development. These results are inline with those of Nee and Opper (2009) and of Chinn and Ito, and also with our results in the growth equation. Bassem Kamar www.gefic.mc

30. Conclusions • Our results clearly explain that Capital Account Liberalization enhances growth, mainly through its impact on FDI inflows and on the financial system development. • The side effect is that it leads to REER appreciation, loss of competitiveness and a limitation of potential contribution of exports to growth (Dilemma?). • They also clearly show the need for improving on the institutional framework, reducing bureaucracy and dealing with corruption in order for the capital account liberalization to play a better role with enhancing growth. Bassem Kamar www.gefic.mc

31. Policy Implications • To answer the dilemma, we need to identify which capital flows leads to the appreciation of the REER, and which doesn’t, and liberalize only these ones (see our FEMISE the published in World Development, Samy Ben Naceur, Damyana Bakrdzhieva and Bassem Kamar) • The countries who suffered from corruption and week institutions might be better-off postponing their capital account liberalization until they are done with their reforms. • In this case, we need a careful coordination between the degree of capital account liberalization, the monetary policy and the exchange rate regime. Bassem Kamar www.gefic.mc

32. The Trilemma and the Two Corners Solution FULL CAPITAL CONTROLS increasing capital mobility Monetary independence Exchange rate stability PURE FLOAT HARD PEG Full financial integration

33. Exchange Rate Stability B Optimum Currency Area or Currency Board Capital Controls Spot S D E Capital Flows Fluctuations Monetary Policy Autonomy A C F High Exchange Rate Fluctuations

34. Thank you very much All comments are welcome Bassem Kamar www.gefic.mc