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On the Hidden Links Between Financial and Trade Opening

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  • Joshua Aizenman

Abstract

This paper investigates the association between commercial and financial openness of developing countries. The data suggest that, controlling for GDP/Capita changes and allowing for country specific effects, increase in a developing country's (exports + imports)/GDP is associated with a highly significant increase in financial openness [measured by (gross private capital inflows + gross private outflows)/GDP]. I outline a model accounting for some of the endogenous linkages between financial and trade openness. I show that developing countries, characterized by high costs of tax collection and enforcement, opt to use financial repression as an implicit tax on savings. The resultant financial repression provides the impetus for capital flight. A frequent mechanism facilitating illicit capital movements is to over invoice imports and under invoice exports with the scale of these activities being proportional to the commercial openness of the economy. This linkage is subject to costly control by the fiscal authorities, where curtailing illicit capital flows requires spending resources on monitoring and enforcement of existing capital controls. The effectiveness of capital controls would increase with the resources spent on monitoring and enforcement per one dollar of international trade. Under these circumstances, greater commercial openness increases the effective cost of enforcing financial repression, thereby reducing the usefulness of financial repression as an implicit tax. This in turn implies that financial reforms tend to be the by-product of greater trade integration.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 9906.

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Date of creation: Aug 2003
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Publication status: published as 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.
Handle: RePEc:nbr:nberwo:9906

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  12. Eggerstedt, Harald & Hall, Rebecca Brideau & Van Wijnbergen, Sweder, 1995. "Measuring capital flight: A case study of Mexico," World Development, Elsevier, Elsevier, vol. 23(2), pages 211-232, February.
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  14. Michael P. Dooley, 1996. "A Survey of Literature on Controls over International Capital Transactions," IMF Staff Papers, Palgrave Macmillan, vol. 43(4), pages 639-687, December.
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  16. Edwards, Sebastian & van Wijnbergen, Sweder, 1986. "The Welfare Effects of Trade and Capital Market Liberalization," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 27(1), pages 141-48, February.
  17. Kevin C. Murdock & Thomas F. Hellmann & Joseph E. Stiglitz, 2000. "Liberalization, Moral Hazard in Banking, and Prudential Regulation: Are Capital Requirements Enough?," American Economic Review, American Economic Association, American Economic Association, vol. 90(1), pages 147-165, March.
  18. Giovannini, Alberto & de Melo, Martha, 1993. "Government Revenue from Financial Repression," American Economic Review, American Economic Association, American Economic Association, vol. 83(4), pages 953-63, September.
  19. Joshua Aizenman & Ilan Noy, 2003. "Endogenous Financial Openness: Efficiency and Political Economy Considerations," NBER Working Papers 10144, National Bureau of Economic Research, Inc.
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