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Title: THE EFFECT OF CAPITAL MARKET LIBERALIZATION IN EASTERN EUROPE: ECONOMIC GROWTH OR FINANCIAL CRISIS


1
THE EFFECT OF CAPITAL MARKET LIBERALIZATION IN
EASTERN EUROPE ECONOMIC GROWTH OR FINANCIAL
CRISIS
Academy For Economic Studies, Bucharest -
Doctoral School of Finance and Banking (DOFIN)
- Dissertation Paper -
  • MSc Student LAVINIA CRISTESCU
  • Coordinator PhD. Professor MOISA ALTAR

Bucharest, July 2008
2
CONTENTS
  • Introduction
  • Literature Review
  • Model Specifications
  • Empirical Analysis
  • The Data
  • Testing The Financial Liberalization Effect
  • Conclusions
  • References

3
I. INTRODUCTION
Openes international financing path
Decreases the cost of capital
Positive effects
Increases investment
FINANCIAL LIBERALIZATION OF EQUITY MARKETS
Leads to a more rapid economic growth
Also, may lead to
A decline in credits portfolio quality
Negative effects
An increase in financial fragility
Macroeconomic volatility to external shocks
FINANCIAL CRISES AND LOSSES
4
II. 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 banks 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.

5
III. MODEL SPECIFICATIONS
  • GROWTH MODEL (Panel, linear)
  • yi,t aXi,t ßFLi,t
    ?Ii,t ei,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
  • ei,t is a random, gaussian component.

6
III. MODEL SPECIFICATIONS
  • CRISIS MODEL (Panel, probit)

Wi,t aZi,t bFLi,t ?i,t
  • Wi,t is a latent, unobserved variable (the
    crisis probability) who depends on
  • - Zi,t a set of control variables
  • - FLi,t dummy financial liberalization
  • - ?i,t random, gaussian variable

F cumulative distribution function of a
standard normal
7
III. MODEL SPECIFICATIONS
GROWTH MODEL CRISIS MODEL
Two step estimation procedure (Maddala (1983))
TREATMENT 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)
8
III. MODEL SPECIFICATIONS
  • 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

F cumulative distribution function of a
standard normal ? probability density of a
standard normal ASSUMPTION the errors are
bivariate normal, but not independent
9
III. MODEL SPECIFICATIONS
  • TOTAL AVERAGE CAUSAL EFFECT OF FINANCIAL
    LIBERALIZATION
  • Due to a change in the financial liberalization
    dummy from 0 to 1

10
IV. EMPIRICAL ANALYSISa. The Data
  • THE DATASET 13 EASTERN EUROPE COUNTRIES
  • TIME PERIOD 1995 2007 (annual series)
  • DATASOURCE AMECO DATABASE, CENTRAL BANKS
    STATISTICAL SERIES and BEKAERT and HARVEYS
    DATABASE FROM DUKE UNIVERSITY

NO. COUNTRY FINANCIAL 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 -
11
IV. EMPIRICAL ANALYSISa. The Data
  • 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

12
IV. EMPIRICAL ANALYSISa. The Data
  • PROBIT DEPENDENT VARIABLE
  • Ii,t through the unobserved, latent variable
    Wi,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 gt first difference)
  • OPENESS TO TRADE openess_trade the ratio
    between (total exports and imports) to GDP (not
    stationary, ADF gt 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, ?100 (stationary, ADF)
  • DUMMY FINANCIAL LIBERALIZATION

13
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
TREATMENT EFFECT MODEL TWO STEPS ESTIMATION
(STATA 9.1.)
14
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • THE ESTIMATORS CONFIDENCE LEVEL

All the regressions coefficients are significant
for a 95 level of confidence
15
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • TESTING THE PROBIT RESIDUALS
  • Distribution

The probit residual is not normally distributed
16
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • Correlograms

There is no evidence of serial residual
correlation
There is no serial correlation of residuals
squared
17
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • TESTING THE GROWTH REGRESSION RESIDUALS

Histogram
Correlogram
The growth residuals are not normally distributed.
The growth residuals are not autocorrelated
18
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • TESTING THE GROWTH AND PROBIT RESIDUALS
    DEPENDENCE

New linear regression
ei,t Ci,t ?i,t ei,t

There is a dependence between the growth and the
probit residuals
gt The two residual series are not normally
bivariate and are not independent
19
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • TOTAL AVERAGE EFFECT OF FINANCIAL LIBERALIZATION

DIRECT EFFECT ße 0.2197727
INDIRECT EFFECT ?e EF(aeZi,t be) F(aeZi,t) 2.10817E-19
TOTAL EFFECT ße ?e EF(aeZi,t be) F(aeZi,t) 0.2197727
On average, the total effect of capital market
liberalization in Eastern Europe countries was a
positive one
20
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • ESTIMATES DISCUSSION GROWTH REGRESSION
  • REAL INITIAL GDP PER CAPITA (-0.289648, p lt
    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 lt 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 lt 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 lt 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 lt
    0.1) leads to an increase in economic growth
    rate, consistent with literature.
  • DUMMY CRISIS (0.3893808, p lt 1) consistent
    with literature (Ranciere, Tornell, Westermann
    (2006)), has a negative influence on growth.

21
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • ESTIMATES DISCUSSION PROBIT REGRESSION
  • GOVERNMENT SIZE - (27.05248, p lt 5) increases
    the crisis probability
  • POPULATION GROWTH (127.7304, p lt 5)
    increases the crisis probability
  • M2 / (INTERNATIONAL RESERVES GOLD)
    (-0.000115, p lt 1) reduces the crisis
    probability and differs from the economic
    hypothesis.
  • INFLATION (1 LAG) (1.216772, p lt 5)
    increases the crisis probability
  • REAL EFFECTIVE EXCHANGE RATE HP DETRENDED
    (-0.140846, p lt 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 (IMFs
    definition). However, it showed no statistical
    significant influence within the model. Instead,
    HP detrended REER has a negative statistical
    significant effect.

22
IV. EMPIRICAL ANALYSISb. Testing The Effect of
Financial Liberalization
  • ESTIMATES DISCUSSION PROBIT REGRESSION
  • FINANCIAL LIBERALIZATION DUMMY (-1.60857, p lt
    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
23
V. 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

24
VI. REFERENCES
  1. 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
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    Effects A Simple Exposition, The Berkeley
    Electronic Press

25
VI. REFERENCES
  1. Kaminski, G. and C. M Reinhart (1999), The Twin
    Crises The Causes of Banking and
    Balance-of-Payments Problems, The American
    Economic Review
  2. Ergungor, E. and J. B. Thomson (2005), Systemic
    Banking Crises, Federal Reserve Bank of
    Cleveland, Policy Discussion Paper
  3. Bekaert, G., C. R. Harvey and C. T. Lundblad
    (2003), Equity Market Liberalization in Emerging
    Markets, Federal Reserve Bank of St. Louis
  4. 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
  5. Goldstein, M., G. L. Kaminski and C. M. Reinhart
    (2000), Assessing Financial Vulnerability, pag.
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  6. Bordo, M., B. Eichengreen, D. Klingebiel and M.S.
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  9. Durlauf, S. N. and D. T. Quah (1998), The New
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  10. Durlauf S. N., P. A. Johnson and J. R. W. Temple
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  12. Kaminski, G. L. and S. L. Schmukler (2003),
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26
VI. REFERENCES
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