The distributional effects of capital account liberalization

Abstract

Episodes of account liberalization increase the Gini measure of inequality, based on panel data estimates for 149 countries from 1970 to 2010. These episodes are also associated with a persistent increase in the share of income going to the top. We investigate three channels through which these impacts could occur. First, the impact of liberalization on inequality is stronger where credit markets lack depth and financial inclusion is low; positive impacts of liberalization on poverty rates also vanish when financial inclusion is low. Second, the impact on inequality is also stronger when liberalization is followed by a financial crisis. Third, liberalization seems to alter the relative bargaining power of firms and workers: the labor share of income falls in the aftermath of capital account liberalization.

Introduction

There has been an increase in global financial integration over the past fifty years, reflected for instance in a steady decline in the number of restrictions that countries impose on cross-border financial transactions. Indices of capital account openness show an increase, on average, across all income groups, with a particularly significant rise occurring at the beginning of the 1990s. The growth effects of this liberalization have been extensively studied but remain the subject of debate, with Henry (2007) claiming a positive impact on growth and Rodrik and Subramania (2009) taking a more skeptical view. This paper studies the distributional effects of capital account liberalization. While there is a vast literature on the distributional effects of trade (Helpman et al., 2015, and references cited therein), there are only a few studies that analyze the relation between financial globalization and inequality. This is surprising because, just as with trade, there are various channels through which capital account liberalization can affect inequality (Claessens and Perotti, 2007).

One channel is through the impact of liberalization on risk-sharing. In theory, financial openness should foster international risk-sharing and domestic consumption smoothing (Kose et al., 2009). In practice, the strength of financial institutions may play a crucial role in determining the extent to which this takes place. In countries with strong financial institutions, financial globalization may reduce inequality by allowing better consumption smoothing and lower volatility. But where financial institutions are weak and access to credit is not inclusive, liberalization may bias financial access in favor of those who are well off and therefore increase inequality.

A second channel is through the effect of liberalization on the likelihood of financial crises. On the one hand, financial crises may reduce inequality as bankruptcies and falling asset prices may have greater impact on those who are better off. On the other hand, financial crises associated with long-lasting recessions may disproportionately hurt the poor and hence increase inequality (de Haan and Sturm, 2016).¹

Finally, capital account openness may affect the distribution of income through its effect on the bargaining power of labor. If capital account liberalization represents a credible threat to reallocate production abroad, it may lead to an increase in the profit-wage ratio and to a decrease in the labor share of income (Harrison, 2002).

This paper contributes to the empirical literature linking finance and inequality.² The contributions of the paper are two-fold. First, we provide evidence that capital account liberalization raises inequality, using a large (unbalanced) panel dataset comprising 149 advanced, emerging and low-income economies from 1970 to 2010. The focus of much of the previous literature has been on within-country experience or on a more limited set of emerging market economies.³ Second, we empirically examine the key mechanisms—such as the extent of financial development, the occurrence of financial crises, and the impact on labor's bargaining power—through which capital account liberalization may affect inequality. We show that each of these mechanisms is operative and needs to be considered in order to have a full picture of the distributional impacts of capital account liberalization.⁴

We check the robustness of our findings to the use of alternate measures of inequality. Specifically, we use the Gini coefficients, the income shares going to the top, poverty rates, and the labor share of income as alternate measures of the distribution of incomes. Given the weaknesses associated with any one measure of inequality, this is an important check on our findings. In addition, we conduct several robustness checks of our findings to address (i) omitted variable bias; (ii) endogeneity bias; and (iii) sensitivity to alternate econometric specifications. The effects of capital account liberalization may very well be confounded by other concurrent political and policy changes. One concern is that liberalization is often enacted by governments of the political right, who may simultaneously pursue other policies that tend to increase inequality. We show, however, that our results are robust to controlling for the political affiliation of governments. We also address endogeneity bias through the use of some novel instruments, including one that attempts to measure the peer pressure a country may feel to liberalize if its main trading partners are liberalizing. Our results are also shown to be robust to alternate econometric specifications. Our baseline results are based on the autoregressive distributed lag model, estimated both by OLS and GMM; in addition, we also use the local projection method of Jordà (2005).

The key findings of the paper are as follows. Episodes of capital account liberalization are associated with a statistically significant and persistent increase in inequality. In particular, we find that capital account liberalization has typically increased the Gini coefficient by about 0.8 percent in the very short term (1 year after the occurrence of a liberalization reform) and by about 1.4 percent in the medium term (5 years after). These episodes are also associated with a persistent increase in the share of income going to the top 1, 5 and 10 percent of the population.

The level of financial development and inclusion and the occurrence of crises play a key role in shaping the response of inequality to financial globalization. In particular, capital account liberalization leads to larger increases in inequality in countries when it is followed by financial crises or in countries with a weaker quality of financial institutions and low financial inclusion. We also find evidence that capital account liberalization lowers the labor share of income, consistent with the view that liberalization curtails the bargaining power of workers relative to firms. As noted earlier, these results are robust to different sets of controls, different estimation techniques, alternate measures of capital account openness and inequality, and checks for omitted variable and endogeneity biases.

The rest of the paper is organized as follows. The next section describes the data and descriptive statistics of the evolution of inequality and capital account openness. Section III analyzes the effect of capital account openness on inequality and provides some robustness checks. Section IV empirically identifies some of the mechanisms through which capital account liberalization affects inequality. Section V summarizes the main findings and discusses policy implications.