Does Financial Sector Development Augment Cross Border Capital Flows?

Sen Gupta, Abhijit and Atri, Pragya (2017): Does Financial Sector Development Augment Cross Border Capital Flows? Published in: CITD Discussion Paper No. 18-02

Abstract

The sharp increase in volatility of capital flows in recent years has resulted in many countries altering the regulations governing the ow of foreign capital only to find such changes having a limited impact. We postulate that one reason for the limited effectiveness of such changes in regulations is the level of financial sector development in the country. As a country enhances its level of financial sector development, it also develops more and more sophisticated financial instruments. The more advanced the domestic financial instruments are, and the deeper is the integration of the domestic financial markets with the world markets, the greater is the likelihood of developing strategies to bypass capital account management measures. In this paper, we undertake various empirical techniques to identify the impact of financial sector development on capital flows, accounting for regulatory regime. The empirical results indicate that there is a threshold effect in the financial sector development capital flow relationship. In particular, financial sector development augments greater integration with global capital flows only above a threshold level. Below the threshold level we find financial development reduces the extent of integration with global capital markets.

• Item Type: MPRA Paper
• Language: English
• Keywords: Capital Flows, Financial Sector Development, Macroeconomic Management
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; F - International Economics > F3 - International Finance > F36 - Financial Aspects of Economic Integration; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

References

Antras, Pol, and Caballero, Ricardo J. (2009), "Trade and Capital Flows: A Financial Frictions Perspective", Journal of Political Economy, 117 (4), pp. 701-744.

Arellano, Manuel, and Bond, Stephen (1991), "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations", Review of Economic Studies, 58 (2), pp. 277-297.

Arellano, Manuel, and Bover, Olympia (1995), "Another Look at the Instrumental Variable Estimation of Error-Components Models", Journal of Econometrics, 68 (1), pp. 29-51.

Ariyoshi, Akira, Kirilenko, Andrei A, Otker, Inci, Laurens, Bernard J, Kriljenko, Jorge I Canales, and Habermeier, Karl F (2000), "Capital Controls; Country Experiences with Their Use and Liberalization", IMF Occasional Papers 190, International Monetary Fund.

Baba, Chikako, and Kokenyne, Annamaria (2011), "Effectiveness of Capital Controls in Selected Emerging Markets in the 2000's", IMF Working Papers 11/281, International Monetary Fund.

Baltagi, Badi H., Demetriades, Panicos O., and Law, Siong Hook (2009), "Financial development and openness: Evidence from panel data", Journal of Development Economics, 89 (2), pp. 285-296.

Basu, Kaushik, Eichengreen, Barry, and Gupta, Poonam (2015), "From Tapering to Tightening:The Impact of the Fed's Exit on India", India Policy Forum, 11 (1), pp. 1-66.

Beck, Thorsten, Demirguc-Kunt, Asli, and Levine, Ross (2010), "Financial Institutions and Markets across Countries and over Time: The Updated Financial Development and Structure Database", World Bank Economic Review, 24 (1), pp. 77-92.

Bick, Alexander (2010), "Threshold Effects of Inflation on Economic Growth in Developing Countries", Economics Letters, 108 (2), pp. 126-129.

Bluedorn, John C, Duttagupta, Rupa, Guajardo, Jaime, and Topalova, Petia (2013), "Capital Flows are Fickle; Anytime, Anywhere", IMF Working Papers 13/183, International Monetary Fund.

Blundell, Richard, and Bond, Stephen (1998), "Initial Conditions and Moment Restrictions in Dynamic Panel Data Models", Journal of Econometrics, 87 (1), pp. 115-143.

Chinn, Menzie D., and Ito, Hiro (2006), "What Matters for Financial Development? Capital controls, Institutions, and Interactions", Journal of Development Economics, 81 (1), pp. 163-192.

Cihak, Martin, Demirguc-Kunt, Asli, Feyen, Erik, and Levine, Ross (2012), "Benchmarking Financial Systems Around the World", Policy Research Working Paper Series 6175, The World Bank.

Claessens, Stijn, Demirguc-Kunt, Asli, and Huizinga, Harry (2001), "How Does Foreign Entry Affect Domestic Banking Markets?", Journal of Banking & Finance, 25 (5), pp. 891-911.

Coelho, Bruno, and Gallagher, Kevin (2010), "Capital Controls and 21st Century Financial Crises: Evidence from Colombia and Thailand", Working Papers wp213, Political Economy Research Institute, University of Massachusetts at Amherst.

de M. Carvalho, Bernardo S., and Garcia, Marcio G.P. (2008), "Ineffective Controls on Capital Inflows Under Sophisticated Financial Markets: Brazil in the Nineties", in Financial Markets Volatility and Performance in Emerging Markets, University of Chicago Press, pp. 29-86.

Demetriades, Panicos O., and Andrianova, Svetlana (2005), "Sources and Effectiveness of Financial Development: What We Know and What We Need to Know", WIDER Working Paper Series 076, World Institute for Development Economic Research (UNU-WIDER).

Fantom, Neil James, and Serajuddin, Umar (2016), "The World Bank's Classification of Countries by Income", Policy Research Working Paper Series 7528, The World Bank.

Forbes, Kristin J., and Warnock, Francis E. (2012), \Capital Flow Waves: Surges, Stops, Flight, and Retrenchment", Journal of International Economics, 88 (2), pp.235-251.

Fratzscher, Marcel (2012), "Capital Flows, Push versus Pull Factors and the Global Financial Crisis", Journal of International Economics, 88 (2), pp. 341-356.

Garber, Peter M. (1998), \Derivatives in International Capital Flows", NBER Working Papers 6623, National Bureau of Economic Research, Inc.

Hansen, Bruce E. (1999), "Threshold Effects in Non-Dynamic Panels: Estimation, Testing, and Inference", Journal of Econometrics, 93 (2), pp. 345-368.

Hutchison, Michael M. (2012), "A Brief Review of Literature on the Effectiveness of International Capital Controls", Asian Development Review, 29 (1), pp. 102-103.

Kaufmann, Daniel, Kraay, Aart, and Mastruzzi, Massimo (2009), "Governance Matters VIII : Aggregate and Individual Governance Indicators 1996-2008", Policy Research Working Paper Series 4978, The World Bank.

Kose, M Ayhan, Prasad, Eswar, Rogoff, Kenneth, and Wei, Shang-Jin (2009), "Financial Globalization: A Reappraisal", IMF Staff Papers, 56 (1), pp. 8-62.

Kremer, Stephanie, Bick, Alexander, and Nautz, Dieter (2013), "Inflation and Growth: New Evidence from a Dynamic Panel Threshold Analysis", Empirical Economics, 44 (2), pp. 861-878.

Lane, Philip R., and Milesi-Ferretti, Gian Maria (2007), "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004", Journal of International Economics, 73 (2), pp. 223-250.

Law, Siong Hook, and Singh, Nirvikar (2014), "Does Too Much Finance Harm Economic Growth?", Journal of Banking & Finance, 41 (C), pp. 36-44.

Levine, Ross (2005), "Finance and Growth: Theory and Evidence", in Handbook of Economic Growth, (editors) Philippe Aghion, and Steven Durlauf, volume 1 of Handbook of Economic Growth, chapter 12, Elsevier, pp. 865-934.

Magud, Nicolas, and Reinhart, Carmen M. (2006), "Capital Controls: An Evaluation", NBER Working Papers 11973, National Bureau of Economic Research, Inc.

McKinnon, Ronald I. (1973), Money and Capital in Economic Development, Brookings Institution, Washington D.C.

Milesi-Ferretti, Gian Maria, and Tille, Cedric (2011), "The Great Retrenchment: International Capital Flows During the Global Financial Crisis", Economic Policy, 26 (66), pp. 285-342.

Ndikumana, Leonce, and Boyce, James K. (2003), "Public Debts and Private Assets: Explaining Capital Flight from Sub-Saharan African Countries", World Development, 31 (1), pp. 107-130.

Ngeno, N.K. (2000), "Capital Flight in Kenya", in External Debt and Capital Flight in Sub-Saharan Africa, (editors) Simeon Ibidayo Ajayi, and Mohsin S. Khan, pp. 300-320.

Pagliari, Maria Sole, and Hannan, Swarnali Ahmed (2017), "The Volatility of Capital Flows in Emerging Markets; Measures and Determinants", IMF Working Papers 17/41, International Monetary Fund.

Patnaik, Ila, Sen Gupta, Abhijit, and Shah, Ajay (2012), "Determinants of Trade Misinvoicing", Open Economies Review, 23 (5), pp. 891-910.

Prasad, Eswar S., Rajan, Raghuram G., and Subramanian, Arvind (2007a), "Foreign Capital and Economic Growth", Brookings Papers on Economic Activity, 38 (1), pp. 153-230.

Prasad, Eswar S., Rogoff, Kenneth, Wei, Shang-Jin, and Kose, M. Ayhan (2007b), "Financial Globalization, Growth and Volatility in Developing Countries", in Globalization and Poverty, NBER Chapters, National Bureau of Economic Research, Inc, pp. 457-516.

Rajan, Raghuram G, and Zingales, Luigi (1998), "Financial Dependence and Growth", American Economic Review, 88 (3), pp. 559-586.

Rajan, Raghuram G., and Zingales, Luigi (2003), "The Great Reversals: The Politics of Financial Development in the Twentieth Century", Journal of Financial Economics, 69 (1), pp. 5-50.

Sahay, Ratna, Arora, Vivek B., Arvanitis, Athanasios V, Faruqee, Hamid, N'Diaye, Papa M, and Griffoli, Tommaso Mancini (2014), "Emerging Market Volatility; Lessons from The Taper Tantrum", IMF Staff Discussion Notes 14/9, International Monetary Fund.