"Endogenous
Financial Openness: Efficiency and Political Economy
Considerations"
Ilan Noy (joint with Joshua Aizenman)
University of Hawai'i at Manoa
Abstract
This paper studies the endogenous determination of financial openness. We outline a framework where financial openness is endogenously determined by the authority's choice of financial repression, and where the private sector determines endogenously the magnitude of capital flight. The optimal financial repression is shown to depend on the efficiency of the tax system (which in turn may be affected by political economy considerations) and the openness of the economy to international trade. We confirm the prediction of the model, showing that de-facto financial openness [measured by (gross private capital inflows + outflows)/GDP] depends positively on lagged trade openness, and GDP/Capita. For the full sample (developing and the OECD) and the developing countries sub-samples, the effect of greater democratization is negative, significant and apparently large. Any one-point increase in the democratization index (out of the 20 points difference between full autocracy and democracy) reduces financial openness (international financial flows) by almost one-half percentage point of GDP. The effect is about half as large when we do not control for the level of corruption. Similar negative dependence applies for measures of political competition. The impact of budget surplus on financial openness is negative for developing countries, but positive for the OECD. The empirical analysis leads us to conclude that a more openly competitive, free and inclusive political system will lead to lower levels of de-facto financial openness after controlling for incomes, macro-economic policy (inflation and budget surpluses), interest rates and commercial openness.