Endogenous Financial and Trade Openness: Efficiency and Political Economy Considerations

This paper studies the endogenous determination of financial and trade openness. We outline a framework where financial openness is endogenously determined by the authority’s choice of financial repression as a taxation device, and where the private sector determines endogenously the magnitude of capital flight. The optimal financial repression is shown to depend on the openness of the economy to international trade, the efficiency of the tax system (which in turn may be affected by political economy considerations). Similar predictions are obtained in a model where authorities pursue an opportunistic policy representing the interest of a narrow pressure group that engages in capital flight due to political uncertainty. Both models predict that larger trade openness would induce greater financial openness. The reverse association -- larger financial openness implies greater trade openness -- may hold due to different channels that are briefly discussed. Hence, we expect to find two-way positive linkages between financial and commercial openness. We confirm these predictions empirically. Having established (Granger) causality, we investigate the relative magnitudes of these directions of causality using the decomposition test developed in Geweke (1982). We find that almost all of the linear feedback between trade and financial openness can be accounted for by G-causality from financial openness to trade openness (53%) and from trade to financial openness (34%). The residual is due to simultaneous correlation between the two measures. In our estimations for the determinants of financial openness, we focus on developing countries and examine a host of macro-economic and political-institutional variables as suggested in our theory. We find that a one standard deviation increase in commercial openness is associated with a 9.5 percent increase in de-facto financial openness (% of GDP), a one standard deviation increase in a democratization index reduces financial openness by 3.5%, and a one standard deviation increase in corruption is associated with a 3% reduction of financial openness. Similar negative dependence applies for measures of political competition. The impact of a budget surplus on financial openness is negative for developing countries, but positive for the OECD. Both the theoretical and empirical analyses lead us to the conclude, counter-intuitively, that a more openly competitive, free and inclusive political system will lead to lower levels of de-facto financial openness.This paper studies the endogenous determination of financial and trade openness. We outline a framework where financial openness is endogenously determined by the authority’s choice of financial repression as a taxation device, and where the private sector determines endogenously the magnitude of capital flight. The optimal financial repression is shown to depend on the openness of the economy to international trade, the efficiency of the tax system (which in turn may be affected by political economy considerations). Similar predictions are obtained in a model where authorities pursue an opportunistic policy representing the interest of a narrow pressure group that engages in capital flight due to political uncertainty. Both models predict that larger trade openness would induce greater financial openness. The reverse association -- larger financial openness implies greater trade openness -- may hold due to different channels that are briefly discussed. Hence, we expect to find two-way positive linkages between financial and commercial openness. We confirm these predictions empirically. Having established (Granger) causality, we investigate the relative magnitudes of these directions of causality using the decomposition test developed in Geweke (1982). We find that almost all of the linear feedback between trade and financial openness can be accounted for by G-causality from financial openness to trade openness (53%) and from trade to financial openness (34%). The residual is due to simultaneous correlation between the two measures. In our estimations for the determinants of financial openness, we focus on developing countries and examine a host of macro-economic and political-institutional variables as suggested in our theory. We find that a one standard deviation increase in commercial openness is associated with a 9.5 percent increase in de-facto financial openness (% of GDP), a one standard deviation increase in a democratization index reduces financial openness by 3.5%, and a one standard deviation increase in corruption is associated with a 3% reduction of financial openness. Similar negative dependence applies for measures of political competition. The impact of a budget surplus on financial openness is negative for developing countries, but positive for the OECD. Both the theoretical and empirical analyses lead us to the conclude, counter-intuitively, that a more openly competitive, free and inclusive political system will lead to lower levels of de-facto financial openness.