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Financial reforms and capital flows to emerging Europe

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Abstract

Analysis of 18 emerging European economies finds domestic financial reforms to be positively associated with net capital inflows. Controlling for standard determinants of capital flows, we find banking sector reforms in particular to be consistent with higher net financial inflows, whereas no such correlation is found for security market reforms or for indicators of financial depth. Additional net inflows are reaped by the EU accession countries. Countries with more reformed banking sectors receive significantly higher FDI and “other” investment net inflows; this is also found for gross financial inflows, but not for gross outflows.

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Notes

  1. In the literature one often uses the current account balance as a measure for net financial inflows. We focus on net financial inflows directly, but also present results using the current account balance. Section 2.2 gives reasons for potential differences between these two measures.

  2. France in the 1970s had deep, but repressed financial markets, whereas Argentina exhibited liberalised, but shallow markets in the 1990s.

  3. See Kirabaeva and Razin (2009) for an excellent survey of this literature.

  4. Past advances in measuring financial liberalisation include Edison and Warnock (2003), who construct an “investable” equity index as a measure for intensity of capital controls, Kaminsky and Schmukler (2003), who develop an index focusing on stock market regulations as well as international transactions, and Bekaert et al. (2005), who determine dates of equity market liberalisations and find a subsequent positive effect on economic growth.

  5. Rajan and Zingales (2003) state that incumbents in financial and industrial sectors oppose financial reforms (which only changes if the economy is open to trade and capital flows). Bartolini and Drazen (1997) come to the conclusion that reforms are likely if access to international capital is facilitated.

  6. The sample comprises Albania, Belarus, Bulgaria, Czech Republic, Estonia, Hungary, Kazakhstan, Kyrgyz Republic, Latvia, Lithuania, Macedonia, Moldova, Poland, Romania, Russia, Slovak Republic, Slovenia, and Ukraine.

  7. The EBRD economists also use incremental scores of 0.33 and 0.66 (for example 2.33 to indicate 2+). A full adoption of the highest international standards would results in a 4+, thus a value of 4.33. However, the highest score given for our sample of countries is four.

  8. See the EBRD Transition Report or the EBRD website http://www.ebrd.com/country/sector/econo/stats/timeth.htm for a detailed description on the EBRD’s scoring method.

  9. In general, the term capital account is often used to describe what the IMF defines as the combined “capital and financial account”.

  10. Refer to Appendix 2 for an overview of the different components of the balance of payments data used.

  11. For an overview of the other variables used in the analysis, refer to Appendix 1 and Sect. 3.2.2.

  12. See the methodology of the EBRD Transition Report for details about these scores.

  13. See Sect. 3.2 for details about these variables.

  14. In the same fashion as in Chinn and Prasad (2003) our focus is on understanding cross-country variations, whereas including fixed effects “would detract from much of the economically meaningful parts of the analysis” (Chinn and Prasad 2003, p. 66).

  15. Thus, we estimate Eq. 2 with \(e_{it}=\rho e_{it-1}+ z_{it}\).

  16. Chinn and Prasad (2003) find an increase in current account balances due to financial deepening (as measured by M2), and Chinn and Ito (2005) report larger current account deficits due to financial deepening (measured as private credit) interacted with legal system indicators. Employing annual data, Hermann and Winkler (2008) report evidence of larger current account deficits due to financial deepening (as measured by M2 and private credit) as well as measures of financial integration and openness for Emerging Asia and Emerging Europe.

  17. To be more specific, we use a dummy variable which has a value of one when the country experiences a systemic financial crisis in the respective 3-year period and zero otherwise.

  18. Non-Ricardian behaviour means that the government’s budget constraint is not internalised by private economic agents.

  19. Specifically, countries that are below their steady state output are expected to be net importers of capital.

  20. For future research it would also be interesting to include measures of economic volatility.

  21. In light of these results, it is crucial to mention that the Emerging European country sample is a special set of countries. While the inclusion of an EU membership dummy does not render the banking reforms variable insignificant, it could be the case that countries reformed their banking sectors in order to fulfill accession requirements for the European Union. However, it is beyond the scope of this paper to analyse the driving forces behind the implementation of financial reforms.

  22. We test the joint significance of the country fixed effects following Baltagi (2005, p. 13). These are jointly significant at the 5% level for the estimations shown in column (2) and (5), and at the 10% level for column (8). In addition, we test if the ommission of country fixed effects in the pooled estimations results in hetereoskedasticity in the residuals using the Breusch-Pagan/Cook-Weisberg test. However, we cannot reject the null hypothesis of homoskedasticity at conventional significance levels in any of our pooled estimations throughout the paper.

  23. Among the control variables, we see that a higher age-dependency ratio implies greater net inflows.

  24. In Sect. 4.3 we relate the results based on the current account to the existing literature.

  25. We run additional robustness tests including a more refined demographic specification following Fair and Dominguez (1991) and Higgins (1998) which leaves our findings unchanged. Moreover, we drop Russia (as a potential outlier) from all estimations, and use private credit as a ratio to GDP (instead of banking deposits), but find the results to be unaffected in each case.

  26. As we cannot disentangle the role of supervision in the banking reform index, we cannot rule out that McKinnon’s and Pill’s (1996) finding of overborrowing (when financial liberalisation without adequate supervision takes place) applies.

  27. The fixed effects are not jointly significant in these estimations, except for column (8).

  28. We observe that overall net FDI inflows to our sample of countries are persistently above 2% of overall GDP.

  29. In the FDI-specific analysis we do not report the results of the country fixed effects specification in order to conserve space. First, the country fixed effects are not jointly significant in any of these estimations. Second, as observed in Table 2, the results for the financial variables are very similar for the pooled and fixed effects specifications. This is also true for the FDI-specific analysis.

  30. See Sect. 2.2 for details.

  31. Following Campos and Kinoshita, we also included the inflation rate and the percentage of oil and natural gas in total exports. As in their subsample for emerging European countries these are not significant nor affecting the coefficients of the other variables.

  32. The corporate governance variable is insignificant in these specifications. Hence, in contrast to Rossi and Volpin (2004), we do not find evidence for more M&A activity in countries with better corporate governance standards.

  33. These estimations are not reported in a table in order to conserve space, but are available upon request.

  34. In the fixed effects estimations, the country fixed effects are jointly significant at the 5% level.

  35. This most likely reflects the fact that overall net inflows are dominated by FDI and Emerging Europe is a net recipient of FDI.

  36. Instead of the NFA position, we use stocks of foreign liabilities and foreign assets, respectively. The existing stock of foreign liabilities plays a negative role in the gross inflows estimations implying that countries which have already accumulated a high foreign liability position receive less inflows.

  37. These results are confirmed in the current account estimation (2). Additionally, more openness to trade is associated with higher current account deficits. We compare these results to findings in the literature in the next subsection.

  38. These are not reported in a table to conserve space, but are available upon request.

  39. Moreover, we estimate a pure cross-sectional specification over the years 1996–2006. The results clearly confirm greater net financial inflows for countries with more reformed banking systems.

  40. However, the study only includes 12 emerging European countries compared to 18 countries in this paper.

  41. However, this index also includes a measure of entry barriers to foreign investors.

  42. Chinn and Prasad (2003) find an increase in current account balances due to financial deepening (as measured by M2), Chinn and Ito (2005) report larger current account deficits due to financial deepening (measured as private credit) interacted with legal system indicators.

  43. Chinn and Prasad (2003), Bussiere et al. (2004), Gruber and Kamin (2007, 2008), and Chinn and Ito (2005) among others also find a positive coefficient on the fiscal balance in medium-term current account estimations using full samples and various subsamples. Chinn and Prasad (2003) stress that the effect is statistically more robust for emerging countries.

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Acknowledgments

This paper was written during my time at Trinity College Dublin. I am grateful to Philip Lane for very helpful advice and comments. I am also thankful for comments and discussions to the editor Fritz Breuss, two anonymous referees, Catia Batista, Doireann Fitzgerald, Patrick Honohan, Christiane Hellmanzik, Nils Holinski, Danielle Kedan, Thomas O’Connor, Paul Scanlon, and Sébastien Wälti. Seminar participants at the International Macro Group and the Graduate Seminars at Trinity College Dublin, the Irish Economic Association Conference 2009, the Dublin Economics Workshop, the INFINITI conference 2009, the Swiss Society of Economics and Statistics Annual Meeting 2009, and at De Nederlandsche Bank provided insightful feedback. Financial support of the Irish Research Council for the Humanities and Social Sciences (IRCHSS) is gratefully acknowledged. The views expressed in this paper are those of the author and do not necessarily reflect those of the European Central Bank.

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    Martin Schmitz

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Appendices

Appendix 1

See Table 7.

Table 7 Data and sources
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Appendix 2

See Table 8.

Table 8 Financial flows data classification
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Schmitz, M. Financial reforms and capital flows to emerging Europe. Empirica 38, 579–605 (2011). https://doi.org/10.1007/s10663-010-9150-3

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