How Financial Development Caused Economic Growth in the APEC: Financial Integration with FDI OR Privatisation without FDI

Politicians fashionably argue in favour of financial development to promote economic growth following the seminal study of King and Levine (1993a, 1993b). Financial development, however, could come through alternative channels that are sometimes not compatible in small open economics. A relatively popular channel promotes privatisation of domestic financial intermediaries but with restrictions on foreign ownership. The other competing channel works through foreign direct investment (FDI) requiring foreign ownership of national assets. Until the last decade of globalisation, from sixties through early nineties, in many APEC countries and especially in the East Asia, privatisation of national banks went hand in hand with a regime of financial repressions. Under that regime governments kept the domestic interest rate above the world rate by imposing barriers against FDI. Recent trend in globalisation creates a political tension between those who welcome and the others who oppose FDI. This paper evaluates the relative contribution of those two alternative channels of financial development to economic growth. The model of analysis builds on King and Levine (1993b) but restricts its attention to small open economies of the APEC. Contrary to the previous findings, privatisation of domestic financial sector alone turns out to have a negative impact on the growth of efficiency measured by the growth of total factor productivity. This discrepancy could possibly be rationalised by a special characteristic of the APEC sample where a negative effect on efficiency came from the regimes of financial repression that blocked FDI. Financial integration led by FDI does bring the prospect of lower economic growth due to increased business fluctuations especially for the small open economies. Nevertheless, it is surprising to find that a significant improvement in efficiency and growth came to the APEC nations through the international channel with the flow of FDI. Consequently, barriers to globalisation out of a purely the nationalist concerns may be ill fated even for small open economies.