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Connecting Two Views on Financial Globalization: Can We Make Further Progress?

Connecting Two Views on Financial Globalization: Can We Make Further Progress?. Shang-Jin Wei IMF, NBER & CEPR Personal Views Only. What does Financial Globalization do? The gap between theories and empirics In theory, benefits through many channels

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Connecting Two Views on Financial Globalization: Can We Make Further Progress?

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  1. Connecting Two Views on Financial Globalization:Can We Make Further Progress? Shang-Jin Wei IMF, NBER & CEPR Personal Views Only

  2. What does Financial Globalization do? • The gap between theories and empirics • In theory, benefits through many channels • Direct: savings, cost of capital, and transfer of technology, • Indirect: development of domestic financial market, more specialization, and better policies • In the data, evidence not strong (Eichengreen, 2000; Prasad, Rogoff, Wei, and Kose, 2003; Kose, Prasad, Rogoff, and Wei, 2006)

  3. Reconciling theories with empirical patterns: • Two independent proposals • The composition effect: • Some capital flows are more beneficial than others • The threshold effect: • Benefits of FG can be realized only if the recipient countries meet some conditions • Eichengreen (2000), Prasad, Rogoff, Wei, and Kose (2003)

  4. Roadmap for discussion • How do the two effects work? • My take on the two effects • The composition is a reflection of the threshold effect • Challenges to this interpretation • Response to the challenge

  5. The composition hypothesis • Not all capital flows are equal • FDI and maybe portfolio inflow are more beneficial to growth than debt • Desoto and Reisen 2001; Bekaert, Harvey, and Lundblad, 2005, JFE • FDI is also less volatile than international bank loans -> More reliance on bank loans increases vulnerability to currency crashes • Frankel and Rose, 1996; Frankel and Wei, 2005

  6. FDI/GDP Loan/GDP Volatility of (FDI/GDP) and (Loan/GDP) (1980-2003, Measured by Standard Deviation)

  7. The Threshold Effect • Certain minimum conditions have to be met before a country can benefit from FG • Institutions • Low corruption / decent rule of law • Otherwise, FG may exacerbate distortions • Reasonable level of financial development • So international capital can be channeled into investment • Human capital

  8. Are the Two Effects Connected? • Yes! • Earlier: Wei (2000, 2001), Wei and Wu (2002) • Recently: Faria and Mauro (2005) • Why? • Insight from the literature from corporate finance • A built-in bias in the international financial architecture

  9. Challenges • Countries with worse financial institutions appear to attract more (not less) FDI • Albuquerque (JIE 2003) • Also see Hausmann and Fernandez-Aris (2000) • Even if public governance and composition of capital inflows are related as hypothesized, how do we know the relationship is causal?

  10. Answers to the Challenges • Separate the effects of financial development and weak governance • Find instrumental variables for government corruption and financial development

  11. Why would weaker financial development be associated with more FDIs? • Caballero, Farhi and Gourinchas, 2005, “An eqbm model of ‘global imbalances’ and low interest rates.” • Ju and Wei, 2005, “A solution to two paradoxes on international capital flows”

  12. Instrumental variable for government corruption: • Initial cost to colonizers –mortality rate of European settlers before 1850 • Acemoglu, Johnson, and Robinson (AER 2001) • Alternative: initial population density in 1500

  13. Instrumental variables for financial development: • Legal origins: La Porta, Lopez-de-silanes, Shleifer, and Vishny (JPE 1998) • Settler mortality

  14. (History-based) instrumental variables • Corruption is mostly affected by settler mortality but not by legal origin • Financial development is affected by both legal origins and settler mortality.

  15. The basic specification: • Composition(j) = β1 Corruption(j) + β2 FinDev(j) + Z(j)Γ + e(j) Zj is a vector of control variables, β1, β2, and Γ are parameters ej is a random error.

  16. First Stage Regressions:Using Histories to Instrument Modern-day Institutions

  17. Explaining the Ratio of FDI/ Total Foreign Liabilities in 2003

  18. Explaining Portfolio Equity/Total Foreign Liabilities in 2003

  19. Explaining Portfolio Debt/ Total Foreign Liabilities in 2003

  20. Explaining Outstanding Foreign Loans/ Total Foreign Liabilities in 2003

  21. Total Capital Inflows Per Capita in Logarithm (2003)

  22. Table 6: Alternative Measure of Institutions – Average of Six World Bank Indicators

  23. Table 7: Adding more control variables (IV Regressions)

  24. Summary (1) • Corruption does not appear to have a strong effect on a country’s total foreign liabilities. • It affects the composition significantly. As FDI and portfolio debt are strongly discouraged, foreign loans take their places. • Corruption increases a country’s vulnerability to a balance-of-payments crisis by altering its composition of capital inflows in an unfavorable direction.

  25. Summary (2) • Financial development does not appear to have a strong effect on total foreign liabilities. • However, a weaker financial system appears to induce more FDIs. • A weaker financial system is likely to discourage inflows of portfolio equity and portfolio debt.

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