Financial Globalization, Convergence and Growth

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 2009 1 / 16

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 2009 2 / 16

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 2009 3 / 16

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 2004. August 2009 3 / 16

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 2004. 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 2009 3 / 16

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 2009 4 / 16

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 2009 4 / 16

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 2009 4 / 16

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 2009 5 / 16

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 2009 5 / 16

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 2009 5 / 16

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 2009 5 / 16

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 2009 6 / 16

Diffusion of technology The growth rate of technology in the leader country is given by g =. A L. A L D August 2009 7 / 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 D August 2009 7 / 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 2009 7 / 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. λ will be a function of the composition of foreign capital: FDI λ = λ Foreign_Cap D August 2009 7 / 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. 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 2009 7 / 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. 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 2009 7 / 16

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 2009 8 / 16

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 2009 8 / 16

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 2009 8 / 16

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 2009 8 / 16

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 2009 8 / 16

Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 (1970-74,..., 2000-04). August 2009 9 / 16

Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 (1970-74,..., 2000-04). Macroeconomic and population data were taken from PWT 6.2 and IFS-IMF. August 2009 9 / 16

Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 (1970-74,..., 2000-04). Macroeconomic and population data were taken from PWT 6.2 and IFS-IMF. Barro and Lee (2000) was the source of educational data. August 2009 9 / 16

Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 (1970-74,..., 2000-04). 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 2009 9 / 16

Data and empirical analysis We have data for 96 countries, with 7 consecutive, non-overlapping 5-years periods from 1970 to 2004 (1970-74,..., 2000-04). 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 2009 9 / 16

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 2009 10 / 16

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 2009 10 / 16

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 2009 10 / 16

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 2009 10 / 16

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) 0.00502** 0.00419** 0.00498** 0.00557*** (2.144) (2.228) (2.543) (3.055) Initial Years of Schooling 0.00337 0.0193 0.0211 0.0119 (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 0.001000* 0.000733* 0.000730 0.000717 (1.786) (1.655) (1.542) (1.525) FDI _ l 0.0864 1.325* 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 596 596 594 594 # Countries 96 96 96 96 Hansen test (p value) 0.380 0.415 0.458 0.452 AR1 test (p value) 0.00154 0.00156 0.00194 0.00237 AR2 test (p value) 0.531 0.540 0.679 0.863 August 2009 11 / 16

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) 0.00557*** 0.00614*** 0.00540*** (3.055) (3.028) (2.725) Initial Years of Schooling 0.0119 0.00381 0.00681 (0.513) (0.188) (0.297) Population Growth 0.937** 0.876** 0.797** ( 2.310) ( 2.565) ( 2.529) Trade Openness 0.000717 0.000628 0.000594 (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 594 584 594 # Countries 96 96 96 Hansen test (p value) 0.452 0.534 0.442 AR1 test (p value) 0.00237 0.00269 0.00217 AR2 test (p value) 0.863 0.763 0.699 D August 2009 12 / 16

Empirical results Table 4 Sensitivity Analysis (1) (2) (3) (4) 1985 2004 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) 0.00705*** 0.00612** 0.00496*** 0.00587*** (2.953) (2.296) (2.948) (3.468) Initial Years of Schooling 0.0414* 0.0494 0.0111 0.0120 (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 0.000362 0.000800* 0.000701 0.000706* (0.804) (1.766) (1.378) (1.678) Africa 0.0293 ( 0.403) Asia 0.0651 (1.059) Eastern Europe 0.0282 (0.521) Latin America 0.0141 ( 0.321) Middle East 0.0110 (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 337 441 594 555 # Countries 95 74 96 89 Hansen test (p value) 0.353 0.990 0.596 0.606 AR1 test (p value) 0.0312 0.00682 0.00190 0.0118 AR2 test (p value) 0.612 0.783 0.612 0.529 D August 2009 13 / 16

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) 0.00591*** 0.00494*** 0.00617** (3.391) (2.797) (2.048) Initial Years of Schooling 0.0352 0.00181 0.00559 (0.281) (0.0751) (0.0887) Initial Years of Schooling. * Initial GDP 0.00293 ( 0.220) Population Growth 0.761* 0.802** 1.265** ( 1.935) ( 2.111) ( 1.995) Trade Openness 0.000767 0.00357 0.00103* (1.358) (1.092) (1.825) Trade Openness * Initial GDP 0.000314 ( 0.949) Private Credit 0.355 (0.467) PrivateCredit * Initial GDP 0.0412 ( 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 594 594 521 # Countries 96 96 92 Hansen test (p value) 0.604 0.531 0.506 AR1 test (p value) 0.00231 0.00230 0.0143 AR2 test (p value) 0.667 0.751 0.906 D August 2009 14 / 16

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) 0.00481*** 0.00649*** 0.00578*** 0.00509* (2.962) (2.676) (2.821) (1.778) Initial Years of Schooling 0.0116 0.0118 0.0161 0.0211 (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 0.000853* 0.000393 0.000662** 0.000944 (1.957) (1.276) (2.054) (1.418) Government (%GDP) 0.00411* ( 1.943) Inflation (log) 0.0218 ( 1.510) Legal Structure and Security of Property Rights 0.0338*** (2.740) Regulation of Credit, Labor, and Business 0.0379*** (2.654) Checks and Balances 0.0258*** (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 561 489 507 509 # Countries 94 91 91 95 Hansen test (p value) 0.910 0.612 0.686 0.324 AR1 test (p value) 0.00387 0.000103 0.0239 0.00850 AR2 test (p value) 0.813 0.664 0.508 0.383 D August 2009 15 / 16

Conclusions 1 Empirical results support our hypothesis that nancial globalization has a positive effect on growth through diffusion of technology. August 2009 16 / 16

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 2009 16 / 16

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 2009 16 / 16

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 2009 16 / 16

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 (1985-2004) and, importantly, for the sample of developing countries. August 2009 16 / 16