Financial Integration, Productivity and Capital Accumulation

Abstract

Understanding the mechanism through which financial globalization affect economic performance is crucial for evaluating the costs and benefits of opening financial markets. This paper is a first attempt at disentangling the effects of financial integration on the two main determinants of economic performance: productivity (TFP) and investments. I provide empirical evidence from a sample of 93 countries observed between 1975 and 1999. The results suggest that financial integration has a positive direct effect on productivity, while it spurs capital accumulation only with some delay and indirectly, since capital follows the rise in productivity. I control for indirect effects of financial globalization through banking crises. Such episodes depress both investments and TFP, though they are triggered by financial integration only to a minor extent. The paper also provides a discussion of a simple model on the effects of financial integration, and shows additional empirical evidence supporting it.

This paper is mainly related to three strands of literature. The literature on growth and development accounting has shown that a large share of cross-country differences in economic performance is driven by total factor productivity (TFP) rather than factor accumulation (physical and human capital).⁴ Hall and Jones (1999) point out that a substantial share of the variation in GDP per worker is explained by differences in TFP and provide evidence that productivity is to a large extent determined by institutional factors. Klenow and Rodriguez-Clare (1997) show that also GDP growth differentials are mainly accounted for by differences in the growth rates of TFP. These results suggest that, if financial globalization is to affect the wealth of nations, it is more likely to do it through its impact on TFP, rather than factor accumulation. This is indeed the main empirical result of the paper.

Several authors suggest that financial development spurs GDP growth by fostering productivity growth, not only by raising the funds available for accumulation. Theoretical papers by Acemoglu, Aghion and Zilibotti (2005), Acemoglu and Zilibotti (1997), Aghion, Howitt and Mayer (2005b) among others show that financial development may relieve risky innovators from credit constraints, thereby fostering growth through technological change. While earlier contributions (e.g., Greenwood and Jovanovic, 1990) suggest that financial development fosters growth simply by increasing participation in production and risk pooling, in the later works the relationship is also driven by advances in productivity. King and Levine (1993), and, in more detail, Beck Levine and Loayza (2000) show evidence of a strong effect of financial development on TFP growth, and only a tenuous effect on physical capital accumulation.

Many papers, extensively summarized in Prasad et al. (2003 and 2006) address the effects of financial globalization on economic growth and volatility, from different perspectives and with various datasets and empirical methodologies. Some studies (for instance, Grilli and Milesi-Ferretti, 1995, Kraay, 2000 and Rodrick, 1998) found that financial liberalization does not affect growth, others that the effect is positive (Levine, 2001, Bekaert et al., 2003 and Bonfiglioli and Mendicino, 2004), yet others that it is negative (Eichengreen and Leblang, 2003). These effects are also shown to be heterogeneous across countries at different stages of institutional and economic development (see Bekaert et al, 2003, Chinn and Ito, 2003 and Edwards, 2001) and countries with different macroeconomic frameworks (Arteta Eichengreen and Wyplosz, 2001). Perhaps surprisingly, very little evidence exists on the effects of financial globalization on the main sources of growth: productivity and capital accumulation. Chari and Henry (2002) find significant effects of equity market liberalization on investments and the Tobin’s Q of listed firms, and conclude that these must be driven by changes in productivity, which they do not explore directly though. Another call for studies on financial integration and productivity is in Prasad et al. (2006).

The remainder of the paper is organized as follows. Section 2 gives a brief overview on growth and development accounting, which leads on to the discussion of my empirical strategy. In section 3, I describe the dataset, with particular attention to the indicators of financial liberalization and banking crises, as well as the construction of the data for physical capital and TFP. Section 4 presents the econometric methodologies, and section 5 reports the results from the estimation of the equations for investments and TFP. Section 6 discusses a simple model that explains the evidence in the previous sections and is consistent with further empirical evidence. Section 7 concludes.

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