Capital Account Liberalization And Financial Deepening

It is still controversial whether capital account liberalization has positive or negative effect on domestic financial deepening. So capital account liberalization is still a highly controversial policy(Eichengreen, 2001).Capital control promotes domestic financial deepening(Mckinnon,1973). Interest rate liberalization can lead to the growth of saving and investment, capital control can also improve the growth of saving and investment by reserving savings in domestic market.In contrast, there are also some reasons to believe negative effects of liberalization.Firstly, with risk-sharing enhancing, yields will increase. But whether savings and investment increase or not depends on the net effect of income effect and substitute effect. If income effect is greater than substitution effect, the net effect is negative, if substitute effect is greater than income effect, the net effect is positive. Secondly, even though liberalized financial sector can provide better insurance for future risk, but this may also decreases the motives of saving. liberalization improves the function of financial sector but not necessarily increases savings and investment, the net effect of liberalization is ambiguous. So the ambiguous empirical results is not surprising(Abiad et al., 2005).This paper mainly studies the above-mentioned theoretical and practical issues. Firstly,this paper reviews the history of capital account liberalization and analyzes the stylized facts about capital account liberalization and financial deepening globally.Historical experience shows that it needs to have certain prerequisites and right time to obtain capital account liberalization gains. Capital account liberalization can play a catalytic role for financial deepening only under certain conditions. Meanwhile, stylized facts show that there exists positive correlation between capital account liberalization and financial deepening, but the relationship between the two is ambiguous in developing countries.Secondly, basing on endogenous financial development theory, this paper constructs a general equilibrium model consisting of entity industry sector, financial sector and household sector. Considering the impact of capital account liberalization on the micro-sector behavioral decision, this paper further theoretically studies the impacts of capital account liberalization on financial deepening, especially focuses on the threshold effects of capital accountliberalization on financial deepening.At the same time, this paper employs cross-country data and China’s data to empirically exam the impacts of capital account liberalization on financial deepening and corresponding threshold effects. What’s more, this paper also sorts out and analyzes the mechanisms of capital account liberalization on financial deepening. At last, according to the above-mentioned research results, this paper propose some policy recommendations.The whole analysis above-mentioned helps to deepen the understanding of the process of capital account liberalization and contributes to make some speculation and judgment for future changes.The whole analysis above-mentioned gets many conclusions.Firstly, the theoretical model concludes that:(1) foreign capital inflow through finance channel increases the supply of capital, decreases the price of industry capital and the return of domestic savings, but increases the capital-labor ratio and improves the labor-income.Saving return’s decrease and labor-income’s increase make the household’s expected income decrease, so the household increases saving rate to smooth the whole consumption.Accordingly, this leads to increase whole social savings and the input and output of financial sector and enlarge the scale of financial sector and further enhance financial deepening.Alternatively, foreign capital inflow through industrial channel has two different impacts on domestic financial deepening. One hand, foreign capital inflow through industrial channel increases the labor-income, decreases the cost of industrial capital and household’s saving return. But this increases the expected income, so the household choose to lower the saving rate to smooth consumption. This leads to decrease the total social saving and the input and output of financial sector which is detrimental to financial deepening finally.On the other hand, foreign capital inflow through industrial channel increases the social return of investment and the household’s saving rate. Accordingly this increases the input and output of financial sector which is conducive to financial deepening.In addition, domestic capital outflow increases the saving’s return but decreases the labor-income. This leads to increase the future income, so the household choose to lower the saving rate. This leads to decrease the whole social saving which is detrimental to financial deepening.Therefore, after capital account liberalization, the direction and mode of capital flow will have different effects on financial deepening.(2)We also find that institution quality and trade openness impact the effect of capital account liberalization on financial deepening through impacting the direction and mode of capital flow after capital account liberalization. So there exists theoretical thresholds.Specifically, only institution quality to a certain level can capital account liberalization brings the inflow of foreign savings and improves the overall level of domestic savings and promotes domestic financial deepening. If institution quality does not yet reach certain level,capital account liberalization will lead to an outflow of domestic savings which is not conducive to financial deepening. So institutional quality is one of the important thresholds of capital account liberalization impacting on financial deepening.Similarly, industry sectors in trade open economy facing more competition, and competition improves the productivity of industry sectors, this will help improve the return of investment. Therefore, after the liberalization of the capital account, foreign capital inflow is in favor of financial deepening. Thus trade openness is also another important threshold of capital account liberalization impacting on financial deepening.Thirdly, this paper’s empirical analysis demonstrates that, in general, capital control deregulation has positive effect on financial deepening. In terms of capital flow direction,deregulation of capital outflow control is not conducive to domestic financial deepening while deregulation of capital inflows control is in favor of financial deepening.In terms of mode of capital flow, gross net inflow has a positive impact on financial deepening and the net inflow of portfolio investment exerts a positive impact on financial deepening while the net FDI inflows is not conducive to financial deepening. The impact of net debt inflow on financial deepening is not clear, which may concerned with whether debt inflow through financial channel or industrial channel.What’s more important, there exists threshold effects of capital account liberalization impacting on financial deepening and trade openness is one of the thresholds. Specifically,affecting by trade openness, the impact of capital account liberalization on financial deepening has two different regimes, so capital account liberalization has different influential coefficients on financial deepening in empirical regression equation depending on tradeopenness. Furthermore, promoting effect of capital account liberalization on financial deepening in economy with total import and export to GDP ratio over 102.39 percent is higher than the economy with total import and export to GDP ratio less than 21.17 percent about 12.09 percent. So the promoting effect of capital account liberalization on financial deepening is much greater in more trade open economy. In another words, with the trade openness increasing, the impact of capital account liberalization on financial deepening is significantly enhancing.There indeed exists institution quality threshold of capital account liberalization on capital market deepening among emerging market countries. That is to say, the effect of capital account liberalization on capital market deepening depends on their institutional quality in emerging market countries. By calculation, for stock market capitalization to GDP ratio is concerned, the threshold value is 3.35 while the threshold value is 4.71 for stock market turnover value to GDP ratio. Both threshold values 3.35 and 4.71 are average values of corruption control and bureaucracy quality index. Before the economy meets the threshold value, the shock of capital account liberalization on the development of the securities market decreases with increasing degree of capital account openness, once the economy meets the threshold condition, the promoting effect of capital account liberalization on the development of the stock market is increasing with the increasing capital account opening degree. This research conclusion has important economic and financial implication. For the development of securities market, the economy needs to control corruption and bureaucracy quality before liberalizing its capital account. Otherwise if control corruption and bureaucracy quality level are less than the threshold condition, the impact of capital account liberalization on stock market will be negative, external capital inflows are used for other purposes or spendthrift.Opening capital account will not be conducive to stock market deepening. If corruption control and bureaucracy quality are above a certain threshold level, the promoting effect of capital account liberalization on stock market deepening will increase.Similarly, for the development of the banking sector, in terms of liquid liabilities to GDP ratio, the threshold value is 7.39 which is higher than the threshold value of stock market. For the impact of capital account liberalization on banking sector, it proposes a higher quality requirements for corruption control and bureaucracy quality. That is to say, the average indexof corruption control and bureaucracy quality need to reach 7.39.When the economy does not meet the threshold, the impact of capital account liberalization on banking sector increases with the capital account openness increasing. When the economy over the threshold, the impact of capital account liberalization on banking sector deepening diminishes with the degree of capital account openness increasing.(3)We find that there are several mechanisms contributed to the occurrence of those above-mentioned effects. Firstly, liberalization can alleviate the protected financial markets suppression and make the real interest rates to rise to the level of competitive equilibrium.Secondly, removal of capital controls makes the domestic and foreign investors to make portfolio diversification and reduce the cost of capital and improve capital allocation efficiency. Thirdly, crowding out inefficient institutions to increase the efficiency of the financial system and exerting pressure to conduct financial infrastructure reforms to ease information asymmetry which leads to moral hazard and adverse selection problems. Finally,but equally important. Getting benefits of opening cross-border financial transactions needs to have reasonable regulations and institutional framework, especially protection for private property and contract execution which motivate those involved in economic activity engaging in lending activities. Therefore, realizing the gains of liberalization on financial deepening only when the economy has a certain degree of economic and institutional development of regulations.(4)This paper analyzes China’s capital account liberalization affecting domestic financial deepening through vector auto regression and vector error correct model and gets some followed conclusions. China’s deregulation of FDI significantly negatively impacts on domestic financial deepening. This shows that China’s foreign direct investment policy has era limitations, there exists over-open of foreign direct investment in China. Although there exists strict regulations on foreign direct investment, but in fact local governments tend to attract foreign investment recklessly to pursue higher local GDP growth for political promotion purpose. So it proposes to improve the management efficiency and structure of foreign direct investment rather than blindly pursue its quantity and size.As the defective domestic financial markets and serious financial repression,deregulation of cross-country loan control does not provide facilities for domestic enterprisesand individuals to borrow cheap money from abroad, otherwise it exacerbates the domestic factor price distortions. So relaxing loan restrictions has negative shock to financial deepening in China.The impact of China’s oversea direct investment deregulation on financial deepening is significantly positive. In recent years, China’s large state-owned enterprises begin to be encouraged to engage in oversea direct investment mainly in order to ease accumulated large foreign exchange reserves pressure. Meanwhile, the international economic environment is also conducive for China’s domestic enterprises to participate oversea direct investment activities after the financial crisis.Interestingly, securities investment deregulation has significant positive effect on financial deepening. Too strict control on securities investment indeed hinders the development of domestic financial market. Therefore it advocates that it is necessary for China to further open up domestic and foreign residents mutual securities investment.In short, it is inappropriate to generally conclude whether capital control or capital openness is favorable. To China, loan regulation and FDI regulation are favorable while securities investment and ODI is the more open the more favorable. In addition, China’s trade liberalization has played an irreplaceable role in financial deepening and macroeconomic growth. Instead, separate capital account liberalization is unfavorable for financial deepening,combined effects of trade liberalization and capital account liberalization has positive effect on financial deepening. So trade liberalization is conducive for China to realize the promoting effect of capital account liberalization on financial deepening.In summary, core ideas and conclusions are as follows: There exists threshold of capital account liberalization affecting financial deepening. If the economy meets those thresholds,capital account liberalization has positive impact on financial deepening. If economy does not yet reach those thresholds, the impact of capital account liberalization on financial deepening is not significant or even negative. Capital account liberalization promotes financial deepening under certain conditions. Only in the case of certain conditions are met,capital account liberalization plays its role in promoting financial deepening. The association degree between capital account liberalization and financial deepening depends on institutional quality, trade openness and many other factors. Therefore, The gains of capitalaccount liberalization is a potential and conditional.These findings have important policy implications: If a country does not reach capital account liberalization’s threshold conditions, it is preferably cautious to open up its capital account, Or actively promoting the formation of the above-mentioned threshold factors and conditions to achieve the promotion role of capital account liberalization on financial deepening. In other words, if a country can not effectively control costs, it is best not to rush to promote the capital account liberalization process. Otherwise the cost of capital account convertibility will exceed its benefits.Compared with prior studies, there exists some innovations in this paper:Firstly, this paper quantitatively analyzes the impact of opening different capital sub-accounts on financial deepening in detail.This paper no longer studies generally the impact of capital account liberalization on financial deepening, but conducts a more detailed study on the impact of capital sub-account liberalization on financial deepening. This paper divides capital account into different sub-accounts and analyzes the impact of different direction and mode of capital flow on financial deepening. Further more, this paper also studies the impact of capital account liberalization on banking sector and stock market deepening respectively. This study indicates that capital outflow control is in favor of financial deepening while capital inflow control is not conducive to financial deepening. Besides, FDI control, ODI control, securities investment control and loans control have different effects on financial deepening and also have different mechanisms. So we can not generally say, whether capital control or capital openness is more favorable. To China, FDI and loans controls are favorable while securities investment and ODI liberalization is more favorable.Secondly, this paper proves the existence of certain thresholds of capital account liberalization impacting on domestic financial deepening both from the theoretical and empirical perspectives.Threshold effect is statistical performance of capital account liberalization conditions theory. The economic implications of threshold effect refers to that if economies meet those thresholds, capital account liberalization has positive effect of financial deepening.Conversely, if economy does not yet reach those thresholds, the impact of capital accountliberalization is not significant or even negative. Meanwhile, capital account liberalization theory suggests that there exists certain conditions to acquire the gains of capital account liberalization, such as macroeconomic stability, efficacious financial supervision, adequate reserves, sound financial institutions and so on. Capital account liberalization has different effect on financial deepening depending on different financial conditions and different stages of development. This paper not only proves the existence of those thresholds from theoretical model but also indicates the presence of threshold effect from cross-country data and China’s data empirical analysis.