1. 1 Endogenous Financial and Trade Openness: Efficiency and Political Economy Considerations NBER working papers #10144, 10496 Joshua Aizenman University of California Santa Cruz Ilan Noy University of Hawaii Manoa

2. 2 The Purpose F Studying the endogenous determination of financial openness F Two benchmark models of financial openness: l Public finance, representative agent l Opportunistic policymaker, facing political uncertainty F Empirical work l Decomposing the linkages between financial and trade openness l Identifying the determinants of financial openness

3. 3 FINANCIAL OPENNESS (t+1) TRADE OPENNESS (t)…(t+2) Higher trade openness reduces optimal financial repression Higher vertical FDI increases international trade, cheaper trade credits, etc.

4. 4 De-facto Financial Openness Most studies focused on the formal acts associated with de-jure financial opening. De-facto financial integration is of independent and considerable interest. l Prasad et. al. (2003), Wei and Wu (2003) The de-facto level of financial openness is the outcome of the interaction between: l de-jure financial openness l enforcement l market forces

5. 5 The public finance model F The policy maker problem: l how to fund given G relying on income tax and on financial repression. F Costly taxes: l income tax is associated with collection costs; l financial repression is associated with expenditure on monitoring and policing. F The consumer’s problem: l capital flight (with risk of appropriation) or domestic bonds (income taxed).

6. 6 Results: The public finance model F Financial repression is optimal below a threshold of fiscal efficiency F Higher cost of tax collection, higher fiscal expenditure and lower commercial openness would increase the “optimal” financial repression. F Cukierman, et al. (1992): functioning democracies and less polarized societies tend to have more efficient tax collection systems, hence tend to be associated with lower taxes and lower capital flight.

7. 7 The opportunistic model F The policy maker controls the income from exporting a natural resource, and faces an uncertain future horizon. F Second period output is determined by first period investment (financed by the policy maker, or by outside parties). F The policy maker chooses between investing (and producing output in the second period) or moving the income offshore (where it will be consumed by the policymaker).

8. 8 Results: The opportunistic model F Higher probability of regime change  l First-period policy maker increases offshore saving and reduces investment. l increases the investment financed by the outside party. F Higher probability of regime change would increase both capital flight and capital inflow  higher de-facto financial openness.

9. 9 Empirical methodology F Determinants of financial openness: l Macro controls: vector X l Average lagged commercial openness – l Political economy controls: vector P l Estimation using the Prais-Winsten procedure: 1. A two-step FGLS using the estimated correlation coefficient obtained from a first-step OLS regression (from the DW statistic). l Reverse specification for trade openness l Decomposition of causality

10. 10 Financial Openness (percent of GDP)

11. 11 Overview of results: Empirics I F De-facto financial openness (FO) depends… l positively on lagged trade openness and GDP/Capita. l negatively on the budget surplus for developing countries (positive for the OECD). l negatively on corruption. l A more openly competitive, democratic, free, and inclusive political system is associated with lower FO. (The effect is more significant once we control for corruption).

12. 12 Overview of results: Empirics II F For developing countries, a one s.d. increase in… l commercial openness increases FO By 9.5%, l the democracy index reduces FO by 3.5%, l corruption index reduces FO by 3%. F Reverse causality from financial to trade openness is also quantitatively important. F Decomposition of links between financial and trade openness (Geweke decomposition)

13. 13 For future research F Disaggregate de-facto financial openness, and de-facto trade openness into their various components. F A more direct empirical investigation into some of our hypotheses is called for: l direct measures of tax collection efficiency (for different tax instruments). l a more direct measure (or a better proxy) for political uncertainty. F Bi-lateral data-set for financial flows