Leap of Faith in Financial Liberalization: Freedom or Submission?

Abstract

Financial liberalization has been cited as a top necessary condition for developing countries in their road to development, promoted by what is called the Washington Consensus with clear evidence since mid-90s. The base for this is that the free capital movement facilitates the efficient allocation of savings, and help channel resources into their most productive uses, expanding the opportunities of portfolio diversification, thereby generating higher risk-adjusted rates of returns, increasing the potential of growth

but the financial reforms that aimed this benefits ended in notables financial crises in a majority of countries after the reforms. This brings up the doubt as the dual effects of Financial Liberalization in economies, topic that has been largely researched in the initial decade of the new century, showing clear connection between financial liberalization and growth, as well as increasing the probability of crises. The academia researchers has focused greatly and remarkably in 8 different conditions of each country for the effects on GDP growth and the risk of crisis, some of the conditions most mentioned in the academia are speed of the reform , development of the financial sector, creditor rights, legal origins, and external dependency for financing, imperfect information and even not trust in initial efficient-market paradigm, asymmetrical information and moral hazard

all of them seems to theoretically have significant effect

but the conditions associated with risk of crisis minimization and maximization of growth has yet to be empirically proven. The theoretical conditions that achieve maximum positive effect on growth and minimize the risk of crises vary, being the most renamed ones: macroeconomic stability, detailed information in the financial sector, adequate supervision, and prudential regulation. This conditions were hardly readable under a clear database unified for all countries which is the main reason for the inexistence of a clear empirical research about them, but the creation in 1996 and development of the World Governance Indicators (WGI) give a new opportunity to, as proxy for the conditions, measure the iteration between financial liberalization and the possible conditions that maximize social utility which is the main aim of this study in an empirical view. One renamed conditions is about asymmetrical information in the financial system, but the Credit Information Base Index developed by the World Bank since 2004 give an approach to what could be the level of asymmetrical information in the financial market. To see what is the effect that liberalization has over GDP empirically and how it varies based on the conditions named before, this is the WGI indicators

as well as to see the relation that financial liberalization has over the risk of crises and how it varies based on the WGI indicators I develop two econometrics models with the World Bank Data and the WGI indicators, the first model is the relation between GDP growth and liberalization replicating five different models with each WGI indicator

then I do a PROBIT model to measure how liberalization enhance the probability of crises seeing the iteration that this has with each WGI indicator used. To measure Financial Liberalization, instead of having a dummy variable that explain the year in which the reform were applied, Chin and Ito (2007) created the KAOPEN as an index that measure a countrys degree of liberalization. For the crisis event the academia has merged into a well-defined definition used in the World Bank Database to recreate a crisis dummy. The data range is from 2004 to 2012, for all countries which the data is available. In the GDP growth and financial liberalization model, results are consistent with the academia and the initiative of the Washington Consensus as the degree of liberalization is positive for all models independently of the degree of the endogenous conditions to investigate, but the iteration terms, this is WGI and KAOPEN, are not significant in all models, to which I can conclude that the change of the degree financial liberalization will not have any influence of the GDP growth based on the performance of the WGI indicators, although liberalization have a statistically maximized effect on growth on those countries which rule of law, institutional quality, government effectiveness and corruption are good at the time of liberalization, specially corruption

but the effect that liberalization has over growth is not significantly clouded by the decrease in the performance of the endogenous conditions, creating great suspicions of the channels through which liberalization affects the growth. For the Crisis and financial liberalization model, the KAOPEN index shows a statistically significant positive effect to the probability of crises in nearly all models, being not significant just in the institutional quality model. This goes in concordance with the academia statements of liberalization increasing the fragility of the financial system and thus inducing crises

but is not expected to see that the iteration terms between the performance of the conditions and the degree of liberalization actually shows a statistically significant positive effect over the risk of crises, not only showing a positive sign in the iteration term but increasing the robustness of the degree of liberalization effect on the probability of crises, being the endogenous condition that maximizes the risk of crises in this model corruption which is a big disruption with the growth model. Based on this results I conclude that although liberalization clearly shows a positive relation with growth, it does it too with the risk of crisis and, in contrast with what theoretically has been exposed before by the academia, a good performance in the endogenous conditions of countries actually increase the effect that liberalization has over the risk of crisis. As a possible response for this I claim that the better performance on the WGI helps to increase the amount of capital inflows and financial participation of investors and thus higher degree of financial deepening, which is one of the main channel that the degree of liberalization has over the financial sector, bringing a higher customization of investment instruments which intensify the difficulty to actually measure the systemic risk, thanks to the complexity of the instruments

as well as the moral hazard of credit rating agencies when they give information that does not represent the actual risk of these instruments.