Financial Globalization, Convergence and Growth

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1 Financial Globalization, Convergence and Growth Delm Gomes Neto Francisco José Veiga Universidade do Minho and NIPE 2009 Far East and South Asia Meeting of the Econometric Society August / 16

2 Outline 1 Introduction 2 The Model Diffusion of technology Implications of the composition of foreign capital on growth, through diffusion of technology 3 Data and empirical analysis 4 Empirical results 5 Conclusions August / 16

3 Introduction The ratio International Financial Integration (stock of foreign assets and liabilities) over GDP gives an idea of the dramatic increase of Financial Globalization in the last decades. August / 16

4 Introduction The ratio International Financial Integration (stock of foreign assets and liabilities) over GDP gives an idea of the dramatic increase of Financial Globalization in the last decades. Following Lane and Milesi-Ferretti (JIE, 2007), this ratio increased by a factor of 7, from 45% in 1970 to over 300% in August / 16

5 Introduction The ratio International Financial Integration (stock of foreign assets and liabilities) over GDP gives an idea of the dramatic increase of Financial Globalization in the last decades. Following Lane and Milesi-Ferretti (JIE, 2007), this ratio increased by a factor of 7, from 45% in 1970 to over 300% in The theory suggests that Financial Globalization would lead to a better allocation of resources, implying an increase of growth, with capital going from industrial to developing countries. D August / 16

6 Introduction (Continued) But there is no robust empirical evidence of a positive effect of Financial Globalization on growth, as stated by Kose, Prasad, Rogoff and Wei (2009) after surveying this literature. See also Obstfeld (2009). August / 16

7 Introduction (Continued) But there is no robust empirical evidence of a positive effect of Financial Globalization on growth, as stated by Kose, Prasad, Rogoff and Wei (2009) after surveying this literature. See also Obstfeld (2009). In general, these papers were looking for a positive effect of a proxy of IFI on growth, in a sense a permanent effect. August / 16

8 Introduction (Continued) But there is no robust empirical evidence of a positive effect of Financial Globalization on growth, as stated by Kose, Prasad, Rogoff and Wei (2009) after surveying this literature. See also Obstfeld (2009). In general, these papers were looking for a positive effect of a proxy of IFI on growth, in a sense a permanent effect. But, according to Henry (JEL, 2007), the neoclassical model only suggests a temporary effect on growth. D August / 16

9 Introduction (Continued) In this paper: We present and test a small open economy model based on Barro, Mankiw and Sala-i-Martin (AER, 1995), where the composition of foreign capital affects growth through diffusion of technology. August / 16

10 Introduction (Continued) In this paper: We present and test a small open economy model based on Barro, Mankiw and Sala-i-Martin (AER, 1995), where the composition of foreign capital affects growth through diffusion of technology. Instead of relying on proxies based on all foreign capital or on its components, we use the composition of foreign capital. August / 16

11 Introduction (Continued) In this paper: We present and test a small open economy model based on Barro, Mankiw and Sala-i-Martin (AER, 1995), where the composition of foreign capital affects growth through diffusion of technology. Instead of relying on proxies based on all foreign capital or on its components, we use the composition of foreign capital. We nd that the composition of foreign capital measured by the FDI ratio Foreign_Cap has a positive effect on growth, through technological cath-up. August / 16

12 Introduction (Continued) In this paper: We present and test a small open economy model based on Barro, Mankiw and Sala-i-Martin (AER, 1995), where the composition of foreign capital affects growth through diffusion of technology. Instead of relying on proxies based on all foreign capital or on its components, we use the composition of foreign capital. We nd that the composition of foreign capital measured by the FDI ratio Foreign_Cap has a positive effect on growth, through technological cath-up. The countries that may gain more with nancial globalization are developing countries. August / 16

13 Figure 1 Effect of the composition of foreign capital on convergence (Added Variable Plots) Lower Quartile of FDI_Liab Fin.Liab. Higher Quartile of FDI_Liab Fin.Liab. D August / 16

14 Diffusion of technology The growth rate of technology in the leader country is given by g =. A L. A L D August / 16

15 Diffusion of technology The growth rate of technology in the leader country is given by g =. A L We assume, following the idea of Nelson and Phelps (AERPP, 1966), that the growth rate of technology in the small open economy is represented by. A L. A A g = A = λ L A +τ. (1) A D August / 16

16 Diffusion of technology The growth rate of technology in the leader country is given by g =. A L We assume, following the idea of Nelson and Phelps (AERPP, 1966), that the growth rate of technology in the small open economy is represented by. A L. A A g = A = λ L A +τ. (1) A There is catch-up to the technology of the leader. This catch-up effect increases with the gap A L A and with the technology absorption rate λ. D August / 16

17 Diffusion of technology The growth rate of technology in the leader country is given by g =. A L We assume, following the idea of Nelson and Phelps (AERPP, 1966), that the growth rate of technology in the small open economy is represented by. A L. A A g = A = λ L A +τ. (1) A There is catch-up to the technology of the leader. This catch-up effect increases with the gap A L A and with the technology absorption rate λ. λ will be a function of the composition of foreign capital: FDI λ = λ Foreign_Cap D August / 16

18 Diffusion of technology The growth rate of technology in the leader country is given by g =. A L We assume, following the idea of Nelson and Phelps (AERPP, 1966), that the growth rate of technology in the small open economy is represented by. A L. A A g = A = λ L A +τ. (1) A There is catch-up to the technology of the leader. This catch-up effect increases with the gap A L A and with the technology absorption rate λ. λ will be a function of the composition of foreign capital: FDI λ = λ Foreign_Cap With relatively more FDI than DEBT, the probability of diffusion of new technologies in the country increases. D August / 16

19 Diffusion of technology The growth rate of technology in the leader country is given by g =. A L We assume, following the idea of Nelson and Phelps (AERPP, 1966), that the growth rate of technology in the small open economy is represented by. A L. A A g = A = λ L A +τ. (1) A There is catch-up to the technology of the leader. This catch-up effect increases with the gap A L A and with the technology absorption rate λ. λ will be a function of the composition of foreign capital: FDI λ = λ Foreign_Cap With relatively more FDI than DEBT, the probability of diffusion of new technologies in the country increases. τ is a procress of innovation, with τ g. In the steady state g = g. August / 16

20 Implications of the composition of foreign capital on growth, through diffusion of technology The empirical model is as follows (ln A is proxied by ln Y ) : ln Y i,t ln Y i,t 1 = γ 1 ln Y i,t 1 + γ 2 S i,t ln Y i,t 1 + γ 3 S i,t + ψ 0 Z i,t + κ i + µ t + ɛ i,t (14) D August / 16

21 Implications of the composition of foreign capital on growth, through diffusion of technology The empirical model is as follows (ln A is proxied by ln Y ) : ln Y i,t ln Y i,t 1 = γ 1 ln Y i,t 1 + γ 2 S i,t ln Y i,t 1 + γ 3 S i,t + ψ 0 Z i,t + κ i + µ t + ɛ i,t (14) Assuming λ (S) = λ S and τ (S) = τ S, the effects of S = given by: FDI Foreign_Cap on growth are (ln Y i,t ln Y i,t 1 ) S i,t = γ 2 ln Y i,t 1 + γ 3. (15) D August / 16

22 Implications of the composition of foreign capital on growth, through diffusion of technology The empirical model is as follows (ln A is proxied by ln Y ) : ln Y i,t ln Y i,t 1 = γ 1 ln Y i,t 1 + γ 2 S i,t ln Y i,t 1 + γ 3 S i,t + ψ 0 Z i,t + κ i + µ t + ɛ i,t (14) Assuming λ (S) = λ S and τ (S) = τ S, the effects of S = given by: FDI Foreign_Cap on growth are (ln Y i,t ln Y i,t 1 ) S i,t = γ 2 ln Y i,t 1 + γ 3. (15) Following the intuition of the model, we expect: D August / 16

23 Implications of the composition of foreign capital on growth, through diffusion of technology The empirical model is as follows (ln A is proxied by ln Y ) : ln Y i,t ln Y i,t 1 = γ 1 ln Y i,t 1 + γ 2 S i,t ln Y i,t 1 + γ 3 S i,t + ψ 0 Z i,t + κ i + µ t + ɛ i,t (14) Assuming λ (S) = λ S and τ (S) = τ S, the effects of S = given by: FDI Foreign_Cap on growth are (ln Y i,t ln Y i,t 1 ) S i,t = γ 2 ln Y i,t 1 + γ 3. (15) Following the intuition of the model, we expect: γ 2 < 0. The greater the gap of technology between the country and the leader, that is the smaller the technology level of the country, the higher the catch-up effect. D August / 16

24 Implications of the composition of foreign capital on growth, through diffusion of technology The empirical model is as follows (ln A is proxied by ln Y ) : ln Y i,t ln Y i,t 1 = γ 1 ln Y i,t 1 + γ 2 S i,t ln Y i,t 1 + γ 3 S i,t + ψ 0 Z i,t + κ i + µ t + ɛ i,t (14) Assuming λ (S) = λ S and τ (S) = τ S, the effects of S = given by: FDI Foreign_Cap on growth are (ln Y i,t ln Y i,t 1 ) S i,t = γ 2 ln Y i,t 1 + γ 3. (15) Following the intuition of the model, we expect: γ 2 < 0. The greater the gap of technology between the country and the leader, that is the smaller the technology level of the country, the higher the catch-up effect. γ 3 > 0. This effect is positive for a given level of technology of the leader and can be associated with innovation. August / 16

25 Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 ( ,..., ). August / 16

26 Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 ( ,..., ). Macroeconomic and population data were taken from PWT 6.2 and IFS-IMF. August / 16

27 Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 ( ,..., ). Macroeconomic and population data were taken from PWT 6.2 and IFS-IMF. Barro and Lee (2000) was the source of educational data. August / 16

28 Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 ( ,..., ). Macroeconomic and population data were taken from PWT 6.2 and IFS-IMF. Barro and Lee (2000) was the source of educational data. Institutional data was obtained from the DPI-WB and EFW (Gwartney and Lawson, 2006). August / 16

29 Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 ( ,..., ). Macroeconomic and population data were taken from PWT 6.2 and IFS-IMF. Barro and Lee (2000) was the source of educational data. Institutional data was obtained from the DPI-WB and EFW (Gwartney and Lawson, 2006). For the composition of foreign capital, we used Lane and Milesi-Ferretti (2007)'s External Wealth of Nations Mark II. August / 16

30 Data and empirical analysis (Continued) Based on equation (14) and noting α = 1 + γ 1, we estimate the following equation: ln Y i,t = α ln Y i,t 1 +γ 2 S i,t ln Y i,t 1 +γ 3 S i,t +ψ 0 Z i,t +κ i +µ t +ɛ i,t (16) August / 16

31 Data and empirical analysis (Continued) Based on equation (14) and noting α = 1 + γ 1, we estimate the following equation: ln Y i,t = α ln Y i,t 1 +γ 2 S i,t ln Y i,t 1 +γ 3 S i,t +ψ 0 Z i,t +κ i +µ t +ɛ i,t (16) Taking into account the potencial endogeneity of several variables, we use the System-GMM estimator based on Arellano and Bover (1995) and Blundell and Bond (1998). August / 16

32 Data and empirical analysis (Continued) Based on equation (14) and noting α = 1 + γ 1, we estimate the following equation: ln Y i,t = α ln Y i,t 1 +γ 2 S i,t ln Y i,t 1 +γ 3 S i,t +ψ 0 Z i,t +κ i +µ t +ɛ i,t (16) Taking into account the potencial endogeneity of several variables, we use the System-GMM estimator based on Arellano and Bover (1995) and Blundell and Bond (1998). In the equation in differences of (16), the instruments used are the lagged levels of the variables (lagged two periods). August / 16

33 Data and empirical analysis (Continued) Based on equation (14) and noting α = 1 + γ 1, we estimate the following equation: ln Y i,t = α ln Y i,t 1 +γ 2 S i,t ln Y i,t 1 +γ 3 S i,t +ψ 0 Z i,t +κ i +µ t +ɛ i,t (16) Taking into account the potencial endogeneity of several variables, we use the System-GMM estimator based on Arellano and Bover (1995) and Blundell and Bond (1998). In the equation in differences of (16), the instruments used are the lagged levels of the variables (lagged two periods). In the equation in levels (16), the instruments used are the lagged differences of the variables (lagged one period). August / 16

34 Empirical results Table 2 Stock and Composition of Foreign Liabilities (1) (2) (3) (4) Initial GDP per capita (log) 0.977*** 0.987*** 0.960*** 0.980*** (26.13) (24.85) (29.73) (31.69) Investment (%GDP) ** ** ** *** (2.144) (2.228) (2.543) (3.055) Initial Years of Schooling (0.106) (0.580) (0.768) (0.513) Population Growth 0.742** 0.691** 0.800*** 0.937** ( 2.156) ( 2.126) ( 2.595) ( 2.310) Trade Openness * * (1.786) (1.655) (1.542) (1.525) FDI _ l * GDP ( 1.361) (1.802) FDI _ l * Initial GDP 0.138* GDP ( 1.914) FDI _ l 0.163* 1.520** Fin. Liabilities (1.700) (2.272) FDI _ l * Initial GDP 0.156** Fin. Liabilities ( 1.964) # Observations # Countries Hansen test (p value) AR1 test (p value) AR2 test (p value) August / 16

35 Empirical results Table 3 Composition of Financial Liabilities (1) (2) (3) FDI _ l Fin. Liab. FDI _ l + Equity _ l Fin. Liabilities Debt _ l Fin. Liab. Initial GDP per capita (log) 0.980*** 0.993*** 0.833*** (31.69) (30.98) (12.94) Investment (%GDP) *** *** *** (3.055) (3.028) (2.725) Initial Years of Schooling (0.513) (0.188) (0.297) Population Growth 0.937** 0.876** 0.797** ( 2.310) ( 2.565) ( 2.529) Trade Openness (1.525) (1.639) (1.600) Composition of Liabilities 1.520** 1.850*** 1.637*** (2.272) (3.748) ( 2.946) Composition of Liabilities * Initial GDP 0.156** 0.193*** 0.169*** ( 1.964) ( 3.337) (2.627) # Observations # Countries Hansen test (p value) AR1 test (p value) AR2 test (p value) D August / 16

36 Empirical results Table 4 Sensitivity Analysis (1) (2) (3) (4) Developing Countries Regional Dummies Non OPEC Initial GDP per capita (log) 0.938*** 0.933*** 1.001*** 0.963*** (32.35) (23.05) (24.79) (27.74) Investment (%GDP) *** ** *** *** (2.953) (2.296) (2.948) (3.468) Initial Years of Schooling * (1.721) (1.473) ( 0.418) (0.407) Population Growth 1.500*** 0.794* 0.729** 1.456*** ( 4.443) ( 1.929) ( 2.253) ( 4.303) Trade Openness * * (0.804) (1.766) (1.378) (1.678) Africa ( 0.403) Asia (1.059) Eastern Europe (0.521) Latin America ( 0.321) Middle East (0.175) FDI _ l 2.010** 1.776*** 1.658*** 1.546** Fin. Liabilities (2.031) (3.078) (2.777) (2.406) FDI _ l * Initial GDP 0.212* 0.185*** 0.181** 0.156** Fin. Liabilities ( 1.886) ( 2.631) ( 1.964) ( 3.337) # Observations # Countries Hansen test (p value) AR1 test (p value) AR2 test (p value) D August / 16

37 Empirical results Table 5 - Controlling for Other Channels of Technological Diffusion (1) (2) (3) Human Capital Trade Financial Development Initial GDP per capita (log) 0.990*** 1.016*** 1.016*** (26.52) (35.11) (14.16) Investment (% GDP) *** *** ** (3.391) (2.797) (2.048) Initial Years of Schooling (0.281) (0.0751) (0.0887) Initial Years of Schooling. * Initial GDP ( 0.220) Population Growth 0.761* 0.802** 1.265** ( 1.935) ( 2.111) ( 1.995) Trade Openness * (1.358) (1.092) (1.825) Trade Openness * Initial GDP ( 0.949) Private Credit (0.467) PrivateCredit * Initial GDP ( 0.520) FDI_liab / Fin.Liabilities 1.552*** 1.400* 3.228** (2.688) (1.957) (2.048) (FDI_liab/Fin.Liabilities) * Initial GDP 0.165** 0.143* 0.354* ( 2.337) ( 1.766) ( 1.902) # Observations # Countries Hansen test (p value) AR1 test (p value) AR2 test (p value) D August / 16

38 Empirical results Table 6 Controlling for Macroeconomic Stability and Institutions (1) (2) (3) (4) Initial GDP per capita (log) 0.973*** 0.931*** 0.960*** 0.973*** (42.79) (26.86) (28.91) (25.81) Investment (% GDP) *** *** *** * (2.962) (2.676) (2.821) (1.778) Initial Years of Schooling (0.515) (0.525) (0.477) (0.721) Population Growth 1.105*** 1.194*** 1.615*** 0.668* ( 3.654) ( 3.365) ( 4.445) ( 1.852) Trade Openness * ** (1.957) (1.276) (2.054) (1.418) Government (%GDP) * ( 1.943) Inflation (log) ( 1.510) Legal Structure and Security of Property Rights *** (2.740) Regulation of Credit, Labor, and Business *** (2.654) Checks and Balances *** (2.808) FDI_liab / Fin.Liabilities 1.662* 2.733*** 2.999*** 1.907** (1.844) (2.866) (3.181) (2.040) (FDI_liab / Fin.Liabilities) * Initial GDP 0.185* 0.296*** 0.332*** 0.197* ( 1.744) ( 2.665) ( 3.038) ( 1.831) # Observations # Countries Hansen test (p value) AR1 test (p value) AR2 test (p value) D August / 16

39 Conclusions 1 Empirical results support our hypothesis that nancial globalization has a positive effect on growth through diffusion of technology. August / 16

40 Conclusions 1 Empirical results support our hypothesis that nancial globalization has a positive effect on growth through diffusion of technology. 2 The greater the share of FDI on total foreign capital, the faster is catch-up and, then, convergence and growth. August / 16

41 Conclusions 1 Empirical results support our hypothesis that nancial globalization has a positive effect on growth through diffusion of technology. 2 The greater the share of FDI on total foreign capital, the faster is catch-up and, then, convergence and growth. 3 Our results are robust to other specications of the composition of foreign capital. August / 16

42 Conclusions 1 Empirical results support our hypothesis that nancial globalization has a positive effect on growth through diffusion of technology. 2 The greater the share of FDI on total foreign capital, the faster is catch-up and, then, convergence and growth. 3 Our results are robust to other specications of the composition of foreign capital. 4 The results are not driven by other channels, like human capital, trade openness or nancial development. August / 16

43 Conclusions 1 Empirical results support our hypothesis that nancial globalization has a positive effect on growth through diffusion of technology. 2 The greater the share of FDI on total foreign capital, the faster is catch-up and, then, convergence and growth. 3 Our results are robust to other specications of the composition of foreign capital. 4 The results are not driven by other channels, like human capital, trade openness or nancial development. 5 Essentially the same results are obtained for the more recent period ( ) and, importantly, for the sample of developing countries. August / 16

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