To liberalize or not to liberalize: Political and economic determinants of financial liberalization

Abstract

Using a sample of 70 emerging market and developing countries, we examine the political and economic factors which affect the government's decision to liberalize the domestic equity markets. We document that the levels of industrialization and financial development, the quality of investor protection, and the level of the government's involvement in the economy are closely associated with the stock market liberalization decision. Furthermore, we find a positive and significant relation between the amount of foreign financial aid received by the governments in emerging market countries and the probability of stock market liberalization.

Introduction

Over the past two decades a great number of emerging market and developing countries have opened their equity markets to foreign investors in a process known as stock market liberalization. Numerous academic studies document that stock market liberalizations improve risk sharing and substantially reduce the cost of capital (Bekaert and Harvey, 2000, Bekaert et al., 2006, Blair Henry, 2000a, Blair Henry, 2003, Chari and Blair Henry, 2004), increase aggregate investment (Blair Henry, 2000b), and promote economic growth (Bekaert et al., 2005, Moshirian, 2008). Recent studies further document that stock market liberalizations reduce agency costs and aggregate stock-return volatility in emerging markets (Cuñado et al., 2006; Ghosh et al., 2008, Umutlu et al., 2010). Peter Blair Henry summarizes the empirical evidence on the effects of equity market liberalizations in a 2003 Congressional Testimony¹: “…all the evidence we have indicates that countries derive substantial economic benefits from opening their stock markets to foreign investors…” Given the abundance of studies examining the effects of stock market liberalizations on firm performance and economic growth, it is surprising that there is a lack of research on the potential determinants of the stock market liberalization decision.² Specifically, if the equity market liberalizations lead to the positive welfare effects documented in the literature, why would governments choose either to delay or to completely resist the liberalization of their stock markets?

In this paper we use an extensive list of countries for which we can identify whether a stock market liberalization occurred and the date of such events, and employ a probit model and a duration model to analyze the factors which affect the liberalization decision. Our results suggest that both political and economic factors influence the government's decision to liberalize the national stock markets. Among the economic factors, the level of financial development, the structure of the economy, the quality of investor protection, and the level of the government's involvement in the economy are significantly related to the likelihood of stock market liberalization. The significant political factors include the government's political orientation and the influence of foreign governments and agencies through the allocation of foreign financial aid.

Our finding that the amount of foreign financial aid received by the governments in the emerging market and developing countries is significantly and positively related to the probability of a stock market liberalization contributes to the long-standing debate about the effectiveness of foreign aid. Specifically, economists have long sought to demonstrate that foreign financial aid promotes economic growth. Many of the empirical studies, however, fail to identify a robust positive effect of foreign financial aid on economic growth (Easterly, 2003, Easterly et al., 2004, Rajan and Subramanian, 2008). Easterly et al. (2004) state the need for further research which “…will continue to explore pressing macroeconomic and microeconomic questions surrounding foreign aid, such as whether aid can foment reforms in policies and institutions that in turn foster economic growth…”(p.780). Our paper provides some evidence in this direction. We find that foreign financial aid is positively related to the likelihood of a stock market liberalization, which in turn can promote economic growth. This does not, however, imply that the overall effect of aid on growth will be positive since any beneficial effects of foreign financial aid can still be offset by adverse spillover effects.³

Our paper also has important implications for the literature on the effects of stock market liberalizations. Most prior studies assume (often implicitly) that equity market liberalizations occur randomly, and therefore, are treated as exogenous events. Our work demonstrates that this assumption is not correct, since many of the factors that influence the stock market liberalization decision are also associated with economic development. Future research should account for the determinants of the liberalization decision in order to address this endogeneity issue.

The remainder of the paper proceeds as follows. Section 2 presents the data and identifies the political and economic factors that can potentially influence the likelihood of a stock market liberalization. Section 3 describes the methodology employed in the analysis of the stock market liberalization decision. Section 4 presents the empirical findings. Section 5 tests the robustness of the empirical findings. Section 6 concludes.