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Empirical Economics

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01-08-2015

Financial liberalization and patterns of international portfolio holdings

Authors: Pedro de Araujo, Olena Mykhaylova, James Staveley-O’Carroll

Published in: Empirical Economics | Issue 1/2015

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Abstract

International financial markets during the past several decades have been characterized by a significant rise in gross international capital flows, increased prominence of nontraditional financial institutions, and globalization of the banking sector. We utilize a 155-country panel framework to present new evidence that financial liberalization is related to reallocation of financial capital around the world. More specifically, we find that deregulation is associated with greater stocks of cross-border financial assets, overall net international indebtedness, and a net portfolio characterized by equity assets and debt liabilities.

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See, for example, Rodrik and Velasco (2000), Lipsey et al. (2001), Wei (2001), Albuquerque (2003), and Prasad et al. (2003).

Financial deregulation has blurred the lines between the objectives, domains, and clients of commercial banks and other financial institutions such as insurance companies, money market funds, and investment banks. Therefore, in our paper we use the term “banking sector” to describe the entirety of the interconnected financial system.

Several other papers have considered the relationship between banking sector characteristics and the resulting cross-border capital flows, albeit on a smaller scale. Campos and Kinoshita (2010) use a sample of over 40 Latin American and transition economies to find that banking sector efficiency (captured by the ratio of overhead costs to total bank assets and the net interest margin) attracts foreign direct investment (FDI). Bruno and Shin (2013) demonstrate that the degree of bank leverage significantly affects cross-country capital flows through the banking sector in 46 developing and developed economies.

Here we measure equity as a combination of portfolio equity and FDI.

Forbes and Warnock (2012) and Fratzscher (2012) include advanced and emerging economies in their analysis, but focus specifically on episodes of substantial increases and decreases in capital flows (examined during the 1980–2009 period in the former, and centered on 2008 crisis in the latter).

“Push” factors, which typically include world interest rates and GDP growth rates, operate by lowering the attractiveness of sending capital to the developed countries. “Pull” factors, such as financial liberalization, macroeconomic reforms, and exchange rate regime, allow foreign investors to choose a particular (typically developing) country of destination for their capital. See Montiel and Reinhart (1999) and Fratzscher (2012) for an overview of the relative empirical importance of these measures.

Haiti received approximately $7.5 billion in aid in the two years since its devastating earthquake in 2010; this capital inflow is almost equal to Haiti’s annual output.

It should be noted that these studies focus specifically on the determinates of FDI flows to developing economies.

We have also attempted to run our estimation for two split samples: advanced economies, and emerging market and developing economies, based on the classification reported in the IMF’s World Economic Outlook reports. However, since the number of countries in the first sample (30) is smaller than the number of instruments, and since we already control for the level of development using per capita GDP, this exercise did not yield any additional insights.

All these tests are robust to violations of the variance-covariance matrix of random effects model. The results of the specifications tests are available from the authors upon request.

Since we are not estimating the four regressions jointly, this minor transformation of the control variables does not compromise our main results.

An alternative way to gauge the relative importance of $\textit{HFI}\,$ is to compute percent contributions of its variation to the actual, rather than fitted, values of capital stocks volatilities, $Y_{i,t}$. Mathematically, this entails eliminating the term $Var\left( \varepsilon _{i,t}\right) $ from the denominator of (2). The results, not reported here for space considerations, are unsurprisingly numerically larger than the ones shown in Table 4.

Staveley-O’Carroll (2013) develops a two-country multiple-asset model in which a global financial intermediary trades in debt and equity assets across national borders. In particular, the model demonstrates that banking liberalization leads to an increase in a country’s gross international asset holdings and to a positive net equity position.

See the special report on international banking, Twilight of the Gods, in the May 11, 2013 issue of the Economist.

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Title: Financial liberalization and patterns of international portfolio holdings
Authors: Pedro de Araujo
Olena Mykhaylova
James Staveley-O’Carroll
Publication date: 01-08-2015
Publisher: Springer Berlin Heidelberg
Published in: Empirical Economics / Issue 1/2015
Print ISSN: 0377-7332
Electronic ISSN: 1435-8921
DOI: https://doi.org/10.1007/s00181-014-0863-1

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