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Endogenous Financial Openness: Efficiency and Political Economy Considerations

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  • Joshua Aizenman
  • Ilan Noy

Abstract

This paper studies the endogenous determination of financial 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), and on political polarization and the degree of opportunism. 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. We confirm the predictions of the models, showing that de-facto financial openness [measured by (gross private capital inflows + outflows)/GDP] depends positively on lagged trade openness, and GDP/Capita. For developing countries, 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 the 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. The theoretical and empirical analysis leads us to conclude that a more openly competitive, free and inclusive political system will lead to lower levels of de-facto financial openness after controlling for incomes, macroeconomic policy (inflation and budget surpluses), interest rates and commercial openness.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10144.

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Date of creation: Dec 2003
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Publication status: published as Joshua Aizenman & Ilan Noy, 2009. "Endogenous Financial and Trade Openness," Review of Development Economics, Blackwell Publishing, vol. 13(2), pages 175-189, 05.
Handle: RePEc:nbr:nberwo:10144

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  13. Aizenman, Joshua, 2008. "On the hidden links between financial and trade opening," Journal of International Money and Finance, Elsevier, vol. 27(3), pages 372-386, April.
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Citations

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Cited by:
  1. Ilan Noy, 2004. "Do IMF Bailouts Result in Moral Hazard? An Events-Study Approach," Working Papers 200402, University of Hawaii at Manoa, Department of Economics.
  2. Yongfu Huang & Jonathan Temple, 2005. "Does external trade promote financial development?," Bristol Economics Discussion Papers 05/575, Department of Economics, University of Bristol, UK.
  3. Hauner, David, 2008. "Credit to government and banking sector performance," Journal of Banking & Finance, Elsevier, vol. 32(8), pages 1499-1507, August.
  4. Chinn,M.D. & Ito,H., 2005. "What matters for financial development? : capital controls, institutions, and interactions," Working papers 4, Wisconsin Madison - Social Systems.
  5. Aizenman, Joshua & Pinto, Brian & Radziwill, Artur, 2004. "Sources for Financing Domestic Capital - is Foreign Saving a Viable Option for Developing Countries?," Santa Cruz Department of Economics, Working Paper Series qt7g18546z, Department of Economics, UC Santa Cruz.
  6. Benjamin E. Diokno, 2010. "Philippine fiscal behavior in recent history," Philippine Review of Economics, University of the Philippines School of Economics and Philippine Economic Society, vol. 47(1), pages 39-87, June.
  7. David Hauner, 2006. "Fiscal Policy and Financial Development," IMF Working Papers 06/26, International Monetary Fund.
  8. Joshua Aizenman & Ilan Noy, 2004. "Endogenous Financial and Trade Openness," NBER Working Papers 10496, National Bureau of Economic Research, Inc.
  9. Aizenman, Joshua, 2008. "On the hidden links between financial and trade opening," Journal of International Money and Finance, Elsevier, vol. 27(3), pages 372-386, April.
  10. Noy, Ilan & Vu, Tam B., 2007. "Capital account liberalization and foreign direct investment," The North American Journal of Economics and Finance, Elsevier, vol. 18(2), pages 175-194, August.
  11. Joshua Aizenman, 2004. "Financial Opening and Development: Evidence and Policy Controversies," American Economic Review, American Economic Association, vol. 94(2), pages 65-70, May.

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