The effects of financial liberalization on economic growth case study for ASEAN countries by using KAOPEN index

UNIVERSITY of ECONOMICS ERASMUS UNIVERSITY ROTTERDAM VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS The Effects of Financial Liberalization on Economic Growth Case Stu

UNIVERSITY of ECONOMICS ERASMUS UNIVERSITY ROTTERDAM

VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

The Effects of Financial Liberalization on

Economic Growth Case Study for ASEAN Countries By Using of

KAOPEN Index

BY

NGUYEN HUNG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, NOV 2016

UNIVERSITY OF ECONOMICS ERASMUS UNIVERSITY ROTTERDAM

VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

The Effects of Financial Liberalization on

Economic Growth Case Study for ASEAN Countries By Using of

KAOPEN Index

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN HUNG

Academic Supervisor:

Professor, Doctor Nguyen Trong Hoai

HO CHI MINH City, November 2016

DECLARATION

“This is to certify that this thesis entitled “The Effects of Financial Liberalization on Economics Growth Case Study for ASEAN Countries by Using of KAOPEN Index”, which is submitted by me in fulfillment of the requirements for the degree

of Master of Art in Development Economics to the Vietnam – The Netherlands Programme (VNP) The thesis constitutes only my original work and due supervision and acknowledgement have been made in the text to all materials used.”

Nguyen Hung

my thesis topic Hence, his expertise has helped me very much to compile necessary skills in thinking, writing, and fulfilling this thesis Moreover, he took time to diligently review my final thesis draft and help to correct the errors and the wrong words usages

Furthermore, I would like to thank Dr Truong Dang Thuy for his enthusiasm of keeping me in schedule of thesis writing I would like also to thank Dr Pham Khanh Nam and Dr Le Van Chon for their helping in developing concept note,

I must show my gratitude toward all lecturers VNP who have broadened my perspectives and encouraged me to fulfill my knowledge as this program requirements Then, I want to say thanks to VNP officers as well as VNP librarian for their support of good conditions and study materials during the study period Next, I wish to express my thank you to all my friends here at VNP Together we have walked and struggled through this whole treasured journey of learning and shared memorable and priceless moments

Last but not least, I am very deeply grateful to my family that is an indispensable element to constitute my achievement

in ASEAN countries, including Viet Nam However, the significant level is not strong in (REM) model, but strong significant in (FEM) This result is also illustrated by the recently integration process of ASEAN The experiment of ASEAN shows that as one form of financial liberalization, FDI have not only brought foreign capital inflows but also the collateral benefit to the host countries

Key Words: Financial Liberalization, economic growth, ASEAN, relationship,

association, total factor of production (TFP), Foreign Direct Investment (FDI)

ABBREVIATION

APEC The Asia-Pacific Economic Cooperation

AREAER Annual Report on Exchange Arrangement and Exchange Restrictions ASEAN the Association of Southeast Asian Nations

IMF International Monetary Fund

GDP Gross Domestic Product

GNP Gross National Product

OECD the Organization for Economic Co-operation and Development

WTO the World Trade Organization

TABLE OF CONTENTS

Page

TABLE OF CONTENTS ……… viii

LIST OF TABLES x

LIST OF FIGURES xi

CHAPTER 1: INTRODUCTION 1

1.1 Problem statements 1

1.2 Research objectives 4

1.3Research questions: 4

1.4 The scope of study 5

1.5 Research structure 5

CHAPTER 2: LTERATURE REVIEW 6

2.1 Theoretical literature 6

2.1.1 Economic Growth and Growth Theory: 6

2.1.2 Financial Development 8

2.1.2.1 Financial Deepening 10

2.1.2.2 Financial Repression……… 10

2.1.2.3 Financial Liberalization ……… 11

2.1.2.4 Financial Liberalization and Economic Growth……… 13

2.2 Empirical Studies……… 18

2.3 Chapter Remarks ……… 23

CHAPTER 3: RESEARCH METHODOLOGY 26

3.1 Model Specification 26

3.2 Measuring Financial liberalization 30

3.2.1 The IMF’s AREAER 31

3.2.2 Quinn’s Measure 32

3.2.3 KAOPEN Measure 34

3.2.4 KA Measure ……… 35

3.2.5 SHARE Measure ……… 35

3.3 Endogenous Problem from the relationship between Financial Liberalization and Economic Growth ……… 36

3.3.1 Instrumental Variables ……… 37

3.4 Measurement of Variables ……… 38

3.4.1 Dependent variable ……… 39

3.4.2 Independent Variables ……… 39

3.4.2.1 KAOPEN indicator (kaopen1) ……… 39

3.4.2.2 Log Initial GDP (lgdp90) ……… 40

3.4.2.3 Government consumption / GDP (gconsume) ……… 40

3.4.2.4 Secondary school enrollment (second) ……… 41

3.4.2.5 Population growth (pop) ……… 41

3.4.2.6 Log life expectancy (llife) ……… 42

3.4.2.7 Dummy Variables: (dlegal) ……… 42

3.5 Data collection ……… 44

3.6 Model Specification ……… 44

3.7 Chapter Remarks ……… 45

CHAPTER 4: RESEARCH RESULTS 46

4.1 Overview Economic Growth and Financial Liberalization in ASEAN……… 46

4.1.1 Overview the economic growth in ASEAN in the period 1990 – 2013……… 46

4.1.2 Foreign Direct Investment (FDI) Inflows into ASEAN……… 48

4.1.3 ASEAN Banking Sector……… 51

4.1.4 Capital account openness in ASEAN countries ……… 53

4.2 Descriptive Statistics ……… 56

4.3 Model Estimation Result ……… 64

4.3.1 Result of Test for Panel Data Model ……… 65

4.3.2 Discussion on the Research Result ……… 67

CHAPTER 5: CONCLUSION AND RECOMMENDATION 73

5.1 Conclusions 73

5.2 Policy implications 75

5.3 Research limitations 77

5.4 Suggestions for Further Research 77

………

REFERENCES 79

APPENDIX A: PANEL REGRESSION MODEL 83

APPENDIX B: RESULTS OF HAUSMAN TEST 85

LIST OF TABLES

Table 2.1: The role of financial Liberalization in economic growth ……… 24 Table 3.1: The expected sign of variables in model ……… 43 Table 4.1: Summary statistics of Variables used in the regressions ……… 56 Table 4.2: The Correlation on the sample observations ……… 64 Table 4.3: The results of Hausman Test ……… 65 Table 4.4: The Result of Regression ……… 66

End

LIST OF FIGURES

Figure 4.1: The average of real GDP growth ……… 47 Figure 4.2: Emerging Asia - FDI inflow, 2000-2013 ……… 48 Figure 4.3: FDI in ASEAN-4, Singapore and Viet Nam (value in US$ million) 49 Figure 4.4: FDI in VIETNAM ……… 50 Figure 4.5 Domestic credit to private sector by banks (% of GDP)……… 52 Figure 4.6 Financial liberalization in ASEAN-4, Singapore and Viet Nam …… 54 Figure 4.7 Financial liberalization in some Asia countries and Viet Nam……… 55 Figure 4.8: The scatter diagram for economic growth rate and financial Liberalization……… 58 Figure 4.9: The scatter diagram among dependent variable and financial

liberalization variable for each ASEAN country ……… 59 Figure 4.10: The scatter diagram among dependent variable and control variables 62

End

CHAPTER 1: INTRODUCTION

1.1 Problem Statement

Recent years have emerged the concern in the issue about globalization, which included international economic integration and financial globalization in across countries, has scholarly instigated by many descriptions and analyses of researchers According to Mckinnon (1973) and Shaw (1973), asserted that the important roles

of financial are essential for technological innovation and economic development

As strong evidences in most research, there is without doubt in this saying However, the study of financial liberalization growth nexus has received opposite opinions, while the tendency toward the world economic integration requires local market openness including financial market, and some adjustments in financial rules, thus providing the going debate about whether positive or negative effect of financial liberalization on economic growth

According to Sachs and Warner (1995), Rodrik (2000) technology and economic institutions have rapidly developed to reach the achievement of advance, the distances between countries become narrower This will encourages more international trade and investment to reduce costs for both consumers and producers, and this stronger requirement to expend trade will in turn enhance the process of international economic integration The common example for international economic integration is the World Trade Organization (WTO), which was established by agreement of more than 120 economies Similarly, the International Monetary Fund (IMF) now involves nearly universal membership, with member countries promise to comply with the basic principles of currency convertibility Recently, going along with the large GDP and the high value of international trade, China’s currency which named Chinese renminbi (RMB) have met the criteria for Special Drawing Right (SDR) basket as the decided of IMF’s Executive board in November 2015, and RMB will become the convertible currency On October 1, 2016 RMB would join the SDR basket, together with the four other global currencies of trade In the SDR basket will be including U.S

dollar: 41.73 percent, Euro: 30.93 percent, Chinese renminbi;10.92 percent, Japanese yen: 8.33 percent, Pound sterling: 8.09 percent respectively The first advantage of freely convertible RMB is that it is very inexpensive to buy and sell,

so that could be reduce the spread cost (the different price in buy and sell) of bank

At smaller scale, there are varying levels of economic integration, including preferential between member countries, the integration between countries in the

same continent, region such as in the Europe have established the Organization for

Economic Co-operation and Development (OECD), European Union (EU), and the development of this is Euro zone In the Asia there are the institutions that can be counted as The Asia-Pacific Economic Cooperation (APEC), the Association of Southeast Asian Nations (ASEAN) The new one, ASEAN Economic Community (AEC) has established in the December 2015, that including Viet Nam and other ASEAN member countries (AEC) is the pledged of member countries to realize the principles of an Economic Community which bases on the idea of the European Union’s model The foundation of AEC is based on the four basic elements which are named as: single market and production base, competitive economic region, equitable economic development, ASEAN’s integration into the globalized economic The aim of this is to turn ASEAN market into the unified market in which free of producing products, free trade of goods and service everywhere in the region of ASEAN It also gives prominence to the competition in production and export activities over the region and within a country To ensuring the development equity, requiring people and firms should be engaged into the process of AEC The last element emphasizes the need that ASEAN must integrate into as a part of the world economic This is the advantage, because of the good position of ASEAN in the middle of global supply chain, trade could be developed connect with other major economics in the world and could be lead to more new business opportunities From the above element, AEC gives the core principles of the ASEAN single market and production base are free flow of goods, services, investment, capital, and skilled labor As demand in promoting trade, ASEAN has

obtained its target in the trade duties reduction Brunei Darussalam, Indonesia, Malaysia, Philippines, Singapore have reduced tariff to 0 %, Cambodia, Lao PDR, Myanmar and Viet Nam also reduce tariff to 0-5% Moreover, to encouraging investment, the investment environment has built in a principle that ensuring the liberalization and protection investment of cross border countries In which, apply the best practices for treatment of foreign investors and investment In addition, implementing the free flow of capital, stock exchanges from member are working together to first step establishing the ASEAN Exchanges This is the aim of promoting ASEAN capital markets and creating more investment opportunities in the region

However, the process of integration requires Viet Nam and many other countries opening the local markets, including domestic financial markets Nowadays, the government polices that focus on controlling markets are received many criticized, for it is likely to be a harm in the efficient functioning and development of financial institutions A saying from the writings of professor McKinnon (1973) asserts that imperfect capital markets play an important role in hindering the growth of developing countries, since the fragmentation of the economies in both institutions and policy measures This shortcoming discourages the effective mobilization and reallocation of resources As ASEAN including Viet Nam possess a region that has more nature resources and advantage in the route of global supply chain, but up to now the region have not developed as expected, so that it is has an incentive to study about the effect of financial liberalization and economic growth in ASEAN countries Recently, financial liberalization becomes one of the most concerns in Scholars and policy makers In the main stream of literature, the positive correlation between financial liberalization in economic growth has been presented in number

of studies such as Quinn (1997), Klein & Olivei (1999), Quinn & Toyoda (2007), Chinn & Ito (2005), Bekaert et al (2005), Henry (2007), Kose et al (2010), among others On the other hand, the other research have not supported for the hypothesis

that liberalization spur growth, that are the studies of Rodrik (1998), Kraay (1998), Stiglitz (2000) and may be many other one

For this reason, this study is conducted to analyze the relationship between financial liberalization and economic growth in ASEAN countries, based on the model of Bekaert et al (2005) in analyzing methodology However, there are some differences from Bekaert et al (2005) Firstly, KAOPEN index is proxy for financial liberalization variable Secondly, the data is new, covering the period 1990-2013 Thirdly, the covered countries are focusing in same region, the ASEAN countries ASEAN is chosen because Viet Nam is one of member countries of AEC, hence the consequence of AEC will influence to the Viet Nam Economy Moreover, among many studies of financial liberalization focus on a large cross section countries and region, it likely to be a few studies that focus on this region Because many scholars agree that financial liberalization can put the pressures to reform on the local financial market, through this to strengthening the financial system Implementing the article of (AEC), Viet Nam will have some changes in financial policy measures This leads to a more concern about the benefit and unexpected effects of financial liberalization on the economic growth These are also the reason for this study is conducted, which intends to find out whether financial liberalization prompt economic growth in ASEAN in the period 1990- 2013 The expectation of this study is finding the positive evidence between financial liberalization and economic growth, for it promoting the integration process

This study tends to find out the impact of financial liberalization on economic growth, by applying the quantitative research to a panel data of the countries of Southeast Asia This study aims to address two main questions:

- Does financial liberalization prompt economic growth in ASEAN countries in the period 1990 – 2013?

- How does financial liberalization affect economic growth of cross countries?

1.4 The scope of the study

The research just focuses on small group of countries, the ASEAN member countries, where have established an Economic Community (AEC) a short time ago As demand for opening financial market is the one of the five core principles

of the ASEAN single market and production base in member countries, the financial liberalization process is expected to be implemented in the ASEAN countries; including Viet Nam The ASEAN is chosen in the sample because the lack of financial liberalization studies focus on ASEAN countries In addition, because Viet Nam is one member of AEC, the need is clarifying the correlation of financial liberalization and economic growth between cross member countries of AEC

1.5 The structure of the study

This paper contains 5 main chapters Following this first chapter of introduction, chapter 2 presents the critical literature review on economic growth, financial development, financial liberalization and the effects of financial liberalization on economic growth Next, regression model and research methodology are exhibited

in chapter 3, specifies the empirical model to examine the effect of financial liberalization on economic growth Chapter 4 gives a brief overview of economic growth and financial liberalization in ASEAN countries Then, the descriptive statistics of the sample, the analyzing, discussing and the result of the study is presented in this chapter Finally, chapter 5 concludes the main findings, limitations and further researches

CHAPTER 2: LITERATURE REVIEW:

This chapter introduces three main parts The first section provides definitions of financial liberalization and reviews theoretical backgrounds about the role of financial liberalization in economic growth The second section summarizes previous empirical researches Based on relevant contents, the third section will depict the construction of conceptual framework for this study

an economy could be seen as an improvement in the quality of life This is not only

as an increase in productive capacity but also as an enhancement the quality of life

to the people of that economy To depict the issue of economic growth, basing on the neoclassical, the exogenous growth theory, endogenous growth theory are developed

Neoclassical growth theory

According to Barro (1991), Howitt (1999), in neoclassical growth theory, economic growth is generally related with technological changes Solow-Swan growth model (exogenous growth) reflects the relationship of output and capital, labor, and technology Economic growth will exert if there is an increase in capital relative to labor until the economy obtains the steady state At the steady state, despite an

increase in capital and labor, economic growth will be unchanged At that time the technology change plays the key role for the economy to overcome that steady state

Endogenous growth theory

Base on the foundations of neoclassical, endogenous growth theory has been developed to explain the long run economic growth as arising from economic activities that are the process to create new technological knowledge As this concept draws the outline of theory, especially the “Schumpeterian” vision variety

in innovation Endogenous growth theory depicts that endogenous growth is long run growth at a rate determined by one or more by factors generated in the economic system instead of outside factors, particularly the factors that dominate the opportunities and incentives to create technological knowledge Because of this,

it can draw the model with one or more these elements such as AK model, in which the engine for growth can be simple a constant return to scale production function This is the first version of endogenous growth theory established from the production function:

Y = AKα (HL)1-α

A is standing for the production technology When put H = K/L is human capital, there is a new production function Y = AK Dividing two sides of equation by L, it give y= Ak This proves that the marginal productivity of capital A does not reduce when the capital stock increases This model still assumes constant return to scale, but it does not explicit the diminishing return to scale The AK theory assumes capital as important element that directly contributes to the production This also increases human capital, then rising linearity output with the capital stock AK theory points out that an economy’s long run grow rate depends on its saving rate This means that a higher saving rate will conduct to a higher growth rate, and higher population growth rates will lead to lower income per capita

Aghion and Howitt (1998) think that there are some different between neoclassical model and endogenous growth theory that in endogenous growth theory the growth per capital can continue without basing on exogenous technology changes, and there is no convergence of income, so that the poor countries will not necessarily growth faster than rich countries However, like with Solow model, the key role of accumulation of production factors and the increasing in productivity in the growing process are also emphasized in endogenous growth theory

In this study both of theories are employed to explain the correlation of the variables in regression model, the factor effecting growth in the economy For example, the convergence of income could be interpreted by neoclassical theory, and the total factor productivity increasing is explained by AK model,

2.1.2 Financial Development

Financial development is defined as an improvement in the quality, quantity and the efficiency of financial system This process involves the combination of many activities and institutions

Beck et al (2000) agree with Schumpeterian view of finance and development: that higher level of financial development spur economic growth by affecting total factor productivity growth According to Levine (2005), financial development happens when financial instruments, markets and intermediaries are improved better, then they affect the information, enforcement and transaction costs

In the literature financial development spur growth by the well functioning financial system that could be briefly presented through two channels: increase in financial deepening that raise investment, and efficient resource allocation which enhance the productivity growth up

Financial deepening is defined as the increasing the ratio of financial assets to GDP that means increasing providing financial services to all levels of a society This could encourage saving, more capital accumulating, for that investors could find the other capital sources to finance for their projects It means improving investment

In addition, financial development plays an important role in raising productivity growth As saving rates increasing, savers could invest in the financial system and gain profits When they do so, capital runs into the financial markets, financial intermediaries where are willingly to screening, selecting and monitoring potential users of capital After that, the good projects will be finance by the outside capital and the unproductive ventures fail to be financed This point out that financial markets and financial intermediaries contribute to distribute resources efficiently

At the end of this process, productivity is increasing in the whole economy

Measurement of financial development

According to Beck et al (2000) financial development could be measured by the size, the activity, and the efficiency of the financial sector

To measure the size of financial sector, the “liquid liabilities ratio” indicator is used This is formed by the currency plus demand and interest bearing liabilities financial intermediaries and non-bank financial intermediaries divided by GDP (Beck et al., 2000); (Goldsmith, 1969); (McKinnon, 1973) This indicator could also be used as proxy for financial deepening since it covers all types of financial institutions The activity of financial sector could be measure by the role of commercial bank compared with central bank or the importance of bank in the allocation of society’s savings “Commercial- Central bank assets” indicator which formed by the ratio of asset of deposit money banks divided by the sum of assets of deposit money banks and central bank assets

The “ratio of credit to the private sector” is another indicator measuring the activity

of financial sector as well as the common measure of the efficiency of resource allocation in the financial sector This indicator is more advantageous than the measures of monetary aggregates because it clarifies the real amount of funds finance to the private sector When the ratio of domestic credit as a percentage of GDP is higher, the economy has higher domestic investment and higher level of financial system development Domestic credit to private sector can be used as a proxy for the private credit (De Gregorio & Guidotti, 1995)

2.1.2.1 Financial Deepening

Financial deepening is defined as the increasing the ratio of financial assets to GDP that means increasing providing financial services to all levels of a society This is measured by formula:

According to King and Levine (1993) financial deepening is one of four indicators

to measure financial development of a country In their study, among many other studies, financial deepening has a significant positive effect on economic growth

2.1.2.2 Financial Repression:

The government policies that focused on restricting and controlling financial markets have been known in literature as financial repression Many governments

feel themselves the need to impose many type of restrictions which are classified

into four categories by the IMF’s Annual Report on Exchange Arrangement and Exchange Restrictions (AREAER)

Since the early 1970s, many scholars have long been concerned that numerous government policies which focused on controlling financial market, for it was felt that these policies are generally taken to be a bad thing normatively that impeded the efficient functioning, development of financial institution and distorted the domestic financial market According to Mckinnon (1973) and Shaw (1973), both authors showed their view of point as a critique of government restrict policies in financial market Many governments feel themselves the need to intervene in the sphere of finance to mobilize and support for the activities that they expect to develop domestic economy The government restrict policies in financial market may be come from some reasons such as the government’s fear of dependence on foreign capitalism, the need to aid state own firms or preventing domestic saver seeking higher return in international market

Quinn and Toyoda (2007) suggest that through the 1980s many developing countries clearly refuse the model of financial openness proposed by developed countries because the fear of dependency interpretation of modern capitalism If a country were to accept the export of foreign capital, it sets itself up for, at best, economic colonialism Some countries, hence, forbid international capital This standpoint shows that developing countries should better keep isolate form rich countries who exploit poor countries was central to developed country wealth and developing country poverty In the development point of view, developing nations should undertake import substitution industrialization which advocates replacing foreign imports with domestic production in order to improve their terms of trade, which requires partial financial closure

2.1.2.3 Financial Liberalization:

Financial liberalization is a very broad term that usually has the meaning that fewer government regulations and restrictions in the financial market In other words, liberalization refers to deregulation or removing of controls Following Kunt and Levine (1996), deregulation of interest rate and more loosened entry policies in exchange for greater private entities, often conducted to significant financial development Specially, in the developing countries where there was considerable repression of government policy in the economy management Nevertheless, the fervor of which financial liberalization was implemented in some countries in the lack of or low performing of lending institutions and instrument, improve more reforms Over the past two decades, many developing countries have reformed their domestic financial markets, due to the requirement of domestic and international developments The short define is that financial liberalization refers more to liberalization or further "opening up" of their own economies to foreign capital and investments, or the simple way: when a country allows money to move in and out of

a country freely

Bumann et al (2013) suggest that in the literature, financial liberalization can raise the efficiency of financial market that help to transform saving into investment Edison et al (2004) summarize that financial liberalization enhances the efficiency

in resource allocation, makes risk diversification more easily available to the firms and investors, speeds up process of financial development, hence improving the economic growth

To measure the degree of financial liberalization of a country, Bumann et al (2013), Quinn et al (2011), Cline (2010) state that up to now, various indicators are developed to measure capital account openness applying for most of countries in the world All of indicators can be discriminated in to 3 groups that are called: de jure,

de facto, and the hybrid indicators The hybrid indicators are the mix between de jure and de facto Most of these measures are created base on information from the Annual Report on Exchange Arrangement and Exchange Restrictions (AREAER)

of the International Monetary Fund (IMF) There are some of indicators that are

developed to assess the degree of financial liberalization such as: “Share” computed

directly from (AREAER), “CAPITAL” by (Quinn, 1997), “KAOPEN” by (Chinn & Ito, 2007), “KA” by (Schindler’s, 2009)

In this study, “KAOPEN” indicator is chosen to proxy for financial openness, because it covers a period time from 1970 to 2013 and is available in internet While Quinn’s CAPITAL data stop at the year 2004, too old to use Usually in the regression estimation, Quinn’s CAPITAL indicator gives the result more significant than KAOPEN indicator However, it is not updated in recent years, so that it is not chosen KA has no data for Lao PDR and Cambodia, and it just cover from 1995 to

2013 Because of this, it could not be used in this study

2.1.2.4 Financial Liberalization and Economic Growth

The mainstream point of view

In general, many scholars have agreed with the perspective that financial liberalization spurs economic growth through several channels: firstly, strengthening local financial market, so that leads more efficient in allocation of resources, more foreign investment, more saving rate, providing opportunities for risk diversification Secondly, help to develop financial systems Thirdly, picking

up the volume of trade and service, and hence ramp up the competitive abilities of local country

Recent years, a great number of descriptions and analyses have been conducted to clarify the relationship between financial liberalization and economic growth In the literature, as the mainstream point of view is that financial liberalization has the positive relationship with economic growth The first time mentioning of liberalization is presented by McKinnon (1973) and Shaw (1973) Both authors critically focus on financial repression, for it was known as restricting and controlling in financial markets This presented by the intervention of government such as enforcement the interest rate ceilings, directed credit and subsidies to banks McKinnon (1973) argue that the weakness of the economics due to both institutions and policy measures lead to reduce the effective of mobilization and reallocation of

resource Relying on an outside money model he point out that a firm faces financing constraints if using only internal finance Because of this, both authors advocate for perfect competition market

Financial liberalization could foster a more strengthening local financial market, so that leads more efficient in allocation of resources, more foreign investment, more saving rate, providing opportunities for risk diversification According to Buman et

al (2013), the neoclassical perspective which assumes that markets are efficient in allocating scare resource, is the source of most of concept in liberalization This perspective has been raised to advocate the positive relationship between financial liberalization of both credit (i.e banking) and capital markets lead to economic growth In the light of this concept, as introducing market principles and competition in banking markets will encourage growth in interest on deposits, and this higher interest conducts to more savings and then more investment Mckinnon (1973), Buman et al (2013) believed that financial liberalization enables to implement market principle and banking competition, this would increase real interest rates on deposits which provide an important boost to saving rates The savers who are encouraged by the higher interest rate tend to save more money The higher saving rates, in turn, providing more amount of resources available to investment funds In addition, when financial liberalization opens up the capital account, capital inflows contribute into capital stock Financial liberalization providing opportunity to risk diversification, Bekaert et al (2005) figured out that improving risk diversification could reduce the cost of equity capital and increase investment Because more foreign capitals are available after financial liberalization, external finance more easily approach, directly decreases financial constraints on firms, so it lead to more investments Moreover, diversification could help to avoid the full effects of domestic shock as Quinn (1997) suggested

Financial liberalization and financial development have a causality correlation Chinn and Ito (2005) pointed that financial liberalization can lead to development of financial systems through these channels such as: lessening financial repression to

protect financial markets that ensuring real interest rate to rise in its competitive market equilibrium Moreover, providing more portfolio diversification could reduce cost of equity capital by reduction in the expected returns to compensate risks In addition, financial liberalization strengthens on financial infrastructure by putting greater pressure for reforming financial system and eliminating inefficient financial institutions In other studies, Klein and Olivei (1999) give the evidence that financial liberalization leads to financial deepening

Financial liberalization could lead to increase more international trade and more integration in world market Removing restrictions on capital account and current account conduct to more easily in payment that help to more trade transaction This will enhance to increase the volume of trade and services between the nation and foreign countries Because of this, the local market is more connected with the world market In the manufacturing sector, the domestic factor of production could

be paid with the relative price at approximate world price (Hekman & Sweeney, 1997); (Quinn, 1997), so that reduces the cost of production and increases the countries competitive abilities

Financial liberalization could raise total factor productivity (TFP) is the suggestion

of recently research Beck et al (2000) agree with Schumpeterian view of finance and development: that higher level of financial development spur economic growth

by affecting total factor productivity growth This point of view obtain the supported from Levine (2001), Bonfiglioli (2008), Henry (2007), Bekaert et al., (2010) among others Henry (2007), emphasize that financial liberalization can enhance the rise in total factor productivity (TFP) The update hypothesis emphasizes that there are something go along with financial liberalization, which could give the benefit for the country, the potential collateral benefit It could enhance the raise of total factor productivity by strengthening institution, knowledge spillover in FDI Moreover, providing opportunities for risk diversification, that could help firms able to invest in higher growth technology projects, thus providing an important boost to TFP

The positive correlation between financial liberalization and economic growth has been presented in number of studies such as Quinn (1997), Klein and Olivei (1999), Quinn and Toyoda (2007), Chinn and Ito (2005), Bekaert et al (2005), Henry (2007), Kose et al (2010), etc On the other hand, the other research have not supported for the hypothesis that liberalization spur growth, that are the studies of Rodrik (1998), Kraay (1998), Stiglitz (2000) The studies that support to financial liberalization can be stated as below: Quinn (1997) processing a cross country regression from year 1960 to 1989, covering 64 countries, proved that financial liberalization is robustly and positively correlated with economic growth He noted that financial liberalization spur growth since it increases the efficiency of investments in capital and labor As a shifting of relating price in an economy, the investments could choose to invest in high demand and (or) low supply in international markets Because of this, investments became more efficient Bekaert

et al (2005) using the equity market openness indicator proxy for financial liberalization which covering 95 countries, demonstrated that the result of the analysis prove the positive effect of financial liberalization on economic growth The result also display that equity market liberalization induce real per capita GDP increase an approximate 1% annual This result was statistically significant and robust to different group of countries, regional indicator variable Chinn and Ito (2005) analyzing the data over the 1970- 2000 period, covering 108 countries, pointed out that financial liberalization contribute to equity market development, and trade openness is precondition for financial liberalization, and thence to financial development Bumann et al (2013) conducted a meta-analysis of financial liberalization and economic growth nexus This analysis use a larger sample than other previous studies, for it based on a sample of 60 other empirical studies This methodology is likely to provide a synthesis of the effect of financial liberalization

on economic growth The result of this analysis proved that financial liberalization has a positive, impact on economic growth, but not robust This suggested that financial liberalization is not a single road to reach strong economic growth To

gain the higher rate of economic growth, the country needs not only to consider the developing in the industrializing process but also in to strengthen the financial system

However, there are have some opposite views are presented that financial liberalization has led in many cases to disappointing results and in some cases even

to economic and financial crises

Stiglitz (2000) argued that it is likely to be a fallacy when considering the financial market as the same ordinary goods and services market As fundamental theory of financial liberalization based on conventional neoclassical model, this perspective explains the operations of financial and capital market are the same ways of ordinary goods and services market work, for it does not enough concern about the special ways of financial and capital markets differ from ordinary markets The main function of capital and financing markets is collecting and processing information, especially in rating the firms and projects which are most likely to gain highest returns, and after that, monitoring the lending funds to ensure that the using them are in suitable approach Relying on this idea, Stiglitz (2000) and other thought that the financial liberalization does not resolve the problem of financial markets such as the asymmetric information This problem can make a barrier to impede the financial intermediation from obtaining the more efficient in the liberalized markets In fact, when the bankers find some bad signals form an economic, they draw their money out of the country This is also true in the case for the most investors and lenders, who look at the economic signals and think that all other investors are looking at the same signals to made a decision when or whether

to draw their money out Moreover, capital market liberalization shows to the world how the country’s vicissitudes related to the changes in economic conditions outside the country When there is a sudden change in lender’s opinions concerning about “emerging market risk”, a considerable capital outflows out of the country

As capital outflow is easier than capital inflow, financial liberalization lead to some

adverse effects, such as greater instability, and the risk of instability will reduce the potential investment in the economies

by number of scholars Klein and Olivei (1999) use the indicator “Share” proxy for

capital account liberalization, regressed the change in financial depth, in the period

of 1986 to 1995, covering cross section of 82 countries, that including developed and developing countries The result of the study is that there is a clearly impact of capital account openness on the changing of financial depth Then they also used the change in the financial depth as dependent variable to estimate a growth model and the result shows that financial development is significant effect on growth per capita The authors find a positive effect of capital account liberalization on economic growth in developed countries, but the result is different in nonindustrial countries, for there is no evidence that capital account liberalization support to

economic growth in nonindustrial countries

Similarly, Bailliu (2000) also obtains the result that capital account openness induces economic growth by instigating the development in financial In this studies the author just focus on developing countries, for the panel data is cover 40 developing countries in the time period from 1975 – 95; he investigate not only the FDI but also a broad of capital flows on economic growth, and highlight the role of domestic financial sectors in the linkage between capital flows and economic growth The result of his study suggested that domestic financial sector play an important role to make sure that international capital flows encourage economic

growth in developing countries He concluded that capital openness spur economic growth in the countries that have obtained a certain level development in the banking system Otherwise, the effect of capital flows on economic growth is found

to be negative The explanation is that capital inflowing into countries with low level developed banking sectors likely to be channeled from productive investment into speculation transactions

Edwards (2001) presented the result of his study, agreeing with the ideas that the effect of financial liberalization on economic growth depend on the level of development of an economy He conclude that capital account openness has a negative effect on economic growth in the countries where are lower level of income, but has a positive effect in industrial countries and in the richer emerging market countries Edward used both Quinn variables and share proxy for financial liberalization in the estimate regression, in the sample of 60 countries, covering the period of 1980s years The result shows that Quinn variables are significant associated with grow in per capital income However, the Share variable gives the result that is not robust in his regression

Bonfiglioli (2008) applied a new method to evaluate the impact of financial liberalization on economic performance Because he thought that it is very important to knowing about mechanisms channel, through which financial liberalization affects economic growth, to assess the cost and the benefits of financial openness He attempted to evaluate the impact of financial liberalization

on economic performance through assessing effect of financial liberalization on total factor of productivity He exploited the data of 70 countries, covering from the period of 25 years from 1975 to 1999 The result is overall positive effect of financial liberalization on total factors productivity growth, and negligible in investment

Bonfiglioli thought that financial openness as integration in the market of financial services that can generate the gains from trade as the same the gains from trade in ordinary goods In the countries with imperfect financial market, financial services

such as screening, monitoring, debt structuring can play a role as important factor of production for firm that need to find more external capital Like as ordinary goods, the differences in quality, diversified and specializing of a product generates demand for trade Because there are some differences in the quality and varieties of financial across countries and sectors, financial liberalization can lead to get typical gains from trade On the other hand, the specialization of financial service helps for all firms in the world to buy any given financial service at the best price Furthermore, firms may find out the most appropriate financial instruments when accessing to new varieties of financial services In the light of these statements, the growth in TFP could be explained by the increasing in allocated efficiency, as suggestion of Galindo et al (2007) in his empirical study One more explanation for the growth of TFP is that financial liberalization provides the tools for international risk diversification As the improvement in risk sharing, the riskier and more productive projects will be easily financed, thus providing an important boost to aggregate TFP

to two sets of regression, one set is 181 observations and another set includes 238 observations The authors consider average growth of per capital income as dependent variable for five non-overlapping five years period In the regression of

five year growth rates, “share” variable is used to proxy for capital account

liberalization There are others comparable variables such as current account controls, and a system of multiform exchange rates, that are exploited from IMF’s

Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER)

In addition, the model includes variables that are often used, for example, political variable, initial GDP, and the level of education The result is not supporting for the assumption that capital account liberalization enhances economic growth In some

cases, the variables “Share”, (CurrAcct), (MultEx) enter with an unexpected sign

However, through this study, there are some supporting evidences for the idea that that financial liberalization associates with external discipline which could help the countries avoid high level of inflation The evidence is that, in a more financial openness country, inflation is lower than close countries When observe the IFM’s indicator variables, the author find that small public sectors and independent central bank have direct good effect on growth and restrained inflation In this case, it is easy to higher assessment the positive effect of capital account liberalization on these variables

Rodrik (1998) found no significant effect of capital account liberalization on growth

in the result of his estimation regression He used the sample that includes 100 countries, from developed to developing countries inclusive, and covers the period

of time from 1975 to 1989 He regress the growth regression model, in which the dependent variable is the percentage of in real income per capital Capital account

liberalization is proxy by “Share” indicator The result shows that there are no

relationship between financial openness and economic growth, or between financial liberalization and inflation He is casts doubt on the impact of financial liberalization on economic growth In his conclusions, he states that boom and bust cycle is the nature of the economic, so that macroeconomic policy measures and financial standards can do something to lessen the potential risks in the economy, but not erase them As advances in technology and communications, capital flow will easily to transfer over the world, ignoring government policy This enhances the domestic financial market become the part of the international market The question is whether a country obtains benefit or not when it speeds up the process of financial liberalization

Kraay (1998) present the result is that have no support for the hypothesis financial liberalization spur economic growth In his regression model, variety variables to

proxy for financial liberalization, such as “Share”, Quinn’s capital account

openness “CAPITAL” indicator, and the other measure base on actual net capital flow The growth in output, that covering the period from 1985 to 1997, is used as dependent variable The form of cross sections data is applied, with one observation per country The estimation methods are both ordinary least squares (OLS) regression and one more approach that lag of capital account liberalization variables

serve as instrument variable The result is no significant of “Share” or “CAPITAL”

indicator on growth In the conclusion, he explains for the lack of strong empirical evidence of the benefit of financial liberalization is that the benefit is concealed by the greater volatility nature of financial liberalization Moreover, the country can get the benefit from financial liberalization when it has a supportive policy and corresponding level of institutional environment

Hellmann et al (2000) providing the other evidence in their study of financial liberalization and prudential regulation nexus in banking system The evidence is that financial Liberalization can give some negative effect on economic growth The authors agree that in a wave of financial liberalization, the competition in the banking sector conduct to lower banks profit and banks tend to engage in gambling They mention a problem of gambling on resurrection that means banks can be choose a risky asset portfolio to seeking higher profit or bonuses when the gamble succeeds In the other side, when the gamble fails, banks loose the depositors, or their insurers Moreover, recent years have a surge of financial liberalization, interest rates have been deregulated, and barrier of the asset choices of bank have been left off, that help banks easily getting risky assets Thus financial liberalization could be a part of the problem This study emphasizes the point of view as financial liberalization encourages higher competition in the banking sector, and this will erodes banks profits The lower profit means that lower franchise values, which leading to lower incentive in lending to good projects and arising the moral hazard

problem Because of this sufficient competition banks will be attracted to gamble, thus putting interest rate liberalization and prudential bank behavior in to the contradiction states Moreover, in the agenda of financial liberalization, the process

of lessening the restriction imposed on banks open a broad new range of transactions such as many derivative trades and foreign currency transactions This will open many roads for banks to engage in gambling operations In addition, restrictions on real estate lending will be eliminated The authors conclude that financial liberalization leads to serious competition between banks, while the freedom of allocating assets and deciding interest rate are given to banks, thus increasing the potential degree of gambling in banking sector

2.3 Chapter Remarks

In summary, it is undoubted that financial liberalization spurs economic growth by

it strengthening local financial market, so that leads more efficient in allocation of resources, more foreign investment, more saving rate, providing opportunities for risk diversification Besides that it helps to develop financial systems Furthermore, picking up the volume of trade and service, and raising total factor productivity (TFP) Hence, ramp up the competitive abilities of local country On the other hand,

it also likely to have some negative effects, that needs to pay more attention to prevent from any harm There is a trade of between benefit and unexpected effects

of liberalization process Although financial transaction involves risks, but engaging

in globalization process is an important trend, so that financial liberalization process will be applied Therefore, risks have to be accepted This study applies the regression estimation technique to examine the effect of financial liberalization on economic growth in ASEAN countries In which, KAOPEN index is used as variable that proxy for financial liberalization Different from previous studies, this studies focus on ASEAN countries that located in dynamic Asian region and the sample is new, cover 10 countries of ASEAN in the period of time from 1990 to

2013

Table 2.1: The role of financial Liberalization in economic growth

Source: Author’s self summary

Financial Liberalization

Encourage investment

in higher growth technologies

New technology and management techniques that help raising the efficiency of firms and give economy wide knowledge spillovers

(TFP)=A

-Financial market development

-Institutional development -Better governance Macroeconomic discipline

FDI

Increased

risk sharing

The role of financial liberalization in economic growth could be illustrated that financial liberalization spurs economic growth by it strengthening local financial market, so that leads more efficient in allocation of resources, more foreign investment, more saving rate, providing opportunities for risk diversification Besides that it helps to develop financial systems Furthermore, picking up the volume of trade and service, and raising total factor productivity (TFP) Hence, ramp up the competitive abilities of local country This hypothesis is supported by many scholars McKinnon (1973), Levine (1996), Quinn (1997), Claessens and Glaessner (1998), Chinn and Ito (2005), Bekeart et al (2005) The update hypothesis, that is suggested by recent empirical studies of Bonfiglioli (2008), Galindo et al (2007), Henry (2007), Kose et al (2006), Kose et al (2009) and other more The update hypothesis emphasizes that there are something go along with financial liberalization, which could give the benefit for the country, the potential collateral benefit It could enhance the raise of total factor productivity by strengthening institution, knowledge spillover in FDI, providing opportunities for risk diversification that could help firms able to invest in higher growth technologies

CHAPTER 3: RESEARCH METHODOLOGY

This chapter contains six sections The first section presents the empirical models employed on previous researches The second section provides measures to assess financial liberalization The third section displays endogenous problem The next section presents the measuring of variables The last two sections contents the data collection and research methodology respectively

3.1 Model Specification:

Cline (2010), Edison et al (2004), Quinn et al (2011) summarize a large body literature to present that there is a lot and ongoing literatures that examine the potential positive effect of financial liberalization through its channels that spur factors of economic contribution in the process of economic growth and development on long run These studies are conducted by verifying the empirical association of financial liberalization and economic growth directly Most of studies rely on the foundation of growth model which the factors are served as variables: the measuring investment, population growth, the degree of education, the value of initial year GDP, etc with the indicators that proxy for financial liberalization Many authors Beck et al (2000); Bekaert et al (2005); Quinn and Toyoda (2008) adopted this similar model in their empirical researches In empirical research, the results of across studies are very wide various This can be implied a number of differences in diverse studies

Cline (2010) confirmed this model is the synthesis approach for calculation the impact of financial liberalization on economic growth The general form is:

g = α + βX + ∑γZ

Where g is the annual growth rate, depending on the model, g can be the total or per capital X is the indicator for financial openness Z is one of i control variables In the case of g, since population growth is exogenous to finance openness, the

coefficient on openness from a specific model can be applied in the analysis without concern whether total or per capital growth has been used as the dependent variable

in specific case of study

In the research that apply the model in which openness interacts with another variable such as domestic banking dept or education level, the form turns to

g = α + βX + δ(XV) + ∑γZ

Where V is variable which can be domestic banking dept or education level

In some cases, to reach the synthesis of country estimates on the model parameters from a number of different studies, both the constant α and the control variables (

∑γZ ) can be drop out of the model, for both of them like the exogeneous to the impact of the financial liberalization When it did so, the model remains only βX and δ(XV) and becomes

g = βX + δ(XV)

Many models from the literature are formed to calculate these terms and get the result that the implied contribution of financial liberalization to economic growth The variable that proxy for financial liberalization, X, will change across the models For the different time periods, the measures set of openness will show the change in the level of openness It is useful in a uniform sharp direction across the different measures for any given countries

As aforementioned, a saying from the writing of Edison et al (2004) content that there has been large and growing empirical studies, which intend to examine the potential benefits of financial liberalization, for its positive impacts on long run economic growth and development These studies directly verify the empirical relationship between financial liberalization and economic growth base on a basis growth model However, there are a number of differences in these studies First, the group of countries as sample in the model is different with other studies Some

authors prefer to study the group of industrial countries, other choice developing countries, and someone else can choose a mixture of the two Second, it is likelihood that the time in the sample periods are different in across studies It may

be specifically important for developing countries, for they present the recent nature

of financial liberalizations Third, the applied methodology and estimation technique in the cross studies are not the same The authors can apply the methodology that use cross-sectional, time series, or panel data Cross section analyses often encounter with some potential limitations, for it is likely to have the problems such as omitted variable bias or endogenous Furthermore, the unobserved countries specific effects may not be controlled by cross section analyses To solve these problems, many authors have been suggested applying dynamic panel data approach instead of cross-sectional data

Bekaert et al (2005) Presents the growth model in simple form as below

Y= βQ 0 + γX i,t + αLib i,t + ε

economy, but the high population growth could reduce the growth rate per capita In some models population growth could have a significant negative sign, but in the other model with OLS standard errors, the population growth has insignificant Quinn et al (2011) present the growth models that applied for this study as below The base model form Quinn & Toyoda (2008)

ΔGDP i,t= β0 + β1(ΔFinancial Globalization Variablei,t-1(2))

+ β2(Income i,t-1) + β3(ΔTrade Openness i,t-1) + β4(ΔInvestment i,t-1) + β5(ΔPopulation Growth i,t-1) + unit effects + period dummies + εi,t

For i = 1,2,…,187, Where [Financial Globalization Variable] = “CAPITAL” indicator This proxy for financial liberalization and calculated by Quinn himself

The base model form Bekaert et al (2005)

ΔGDP i,t= β0 + β1(ΔFinancial Globalization Variablei,t-1(2))

+ β2(Income i,t-1) + β3(LifeExpectancy i,t-1) + β4(ΔEducational Attainment i,t-1) + β5(ΔPopulation Growth i,t-1) + β6(Government Expenditure i,t-1) + period dummies

+ unit effects + εi,t For i = 1,2,…,187,

Where

[Financial Globalization Variable] =

[CAPITAL]: Developed by Quinn (1997)

[Official Liberalization indicator]: Dating equity market liberalization Based on

the assessment that foreign Investors officially have the opportunity to invest in

[CAPITAL]

[Official Liberalization indicator] [IMF Capital account openness]

domestic equity securities or not It take the value of 1 when fully liberalized country and zero otherwise It is developed by Bekaert et al (2005)

[IMF Capital account openness] is the measurement of capital account openness

by employing the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER)

Through the two above models, the financial liberalization variables are changed belong to the author’s choice The control variables are similarly the same, but model of Bekaert et al (2005) is simpler than Quinn’s model In this study, model

of Bekaert et al (2005) is applied for the sample in ASEAN countries Because Quinn’s indicator has just counted to the year 2004, after that there is no data Quinn indicator will be replaced by Chinn’s indicator that is available to 2013 data, the newest data of Chinnn’s indicator It also is the good proxy for financial

liberalization

3.2 Measuring Financial liberalization

According to Bumann et al (2013), in the literature, there are scholarly three broad categories of method to measure the financial liberalization Relying on the referring of each method, the categories are named as capital account liberalization, equity market liberalization and banking sector liberalization Furthermore, there are multidimensional measures which combine the factor of three methods Quinn

et al (2011), Cline (2010) agreed that it is likelihood that most studies prefer to capital account measures as proxies for financial liberalization Hence, measures of other methods are not used more regularly

One of the main point for any database discussion of the efficiency of financial liberalization on economic growth is the different empirical measures which have been employed to gauge whether a country remove the restriction on financial capital across its border In practice, the scholars can themselves evolve the computing method to scoring or creating the indicators to measuring the financial