The authors examine the association between financial liberalization and economic
growth. The authors determine that average annual real economic growth increases
by 1 percent subsequent to equity market liberalization across a sample of
developing and developed countries. This result is robust across alternative
liberalization indicators, model specifications, time period selection, and
sample size. When comparing post-liberalized countries to those that did not
undertake financial liberalization, the results are even more pronounced, with
average annual real GDP growth a full 2.2 percent higher for the liberalized
countries.
Economic theory suggests that financial systems with fewer constraints achieve higher
investment (with lower financing cost) and economic growth rates. This study empirically
tests the relationship between economic growth and equity market liberalization. Equity
market liberalization occurs when foreign investors have the ability to invest in
domestic equity securities and foreign securities are available to domestic investors.
Regressing economic growth on indicators of equity market liberalization, the authors
determine that average annual real economic growth increases by about 1 percent
following equity market liberalization across four different country samples and through
time. To confirm a robust association that equity market liberalization matters for
economic growth, the authors use a number of econometric model specifications involving
regressions of real per capita GDP growth on multiple equity market liberalization
indicators and other control variables. Indicators of equity market liberalization
include: (1) the year of formal regulatory change (i.e., official equity market
liberalization); (2) the first sign of equity market liberalization defined as the year
associated with the earliest of the following events: official liberalization,
announcement of the first American Depositary Receipt, or the launch of the first
country fund; and (3) the intensity of equity market liberalization based on the ratio
of the market capitalization of the constituent firms composing the International
Finance Corporation (IFC) Investable Index to those that compose the IFC Global Index
for each country.
To account for the possibility that higher growth might be caused by factors other than
equity market liberalization during the study period, the authors include different
mixes of control variables across model specifications. In particular, capital account
liberalization, past banking-sector reform, macroeconomic stability, the world business
cycle, and reform of the legal infrastructure were all candidate control variables
across the models under review. The authors find that the impact of equity market
liberalization on growth is not weakened when other potential variables associated with
growth are included in the regressions.
The authors then examine the possibility that higher growth might be caused by other
contemporaneous domestic reforms rather than equity market liberalization. After
accounting for reforms with respect to the legal environment, the quality of
institutions, the investment condition, and the degree of financial development, the
authors find that although some portion of economic growth is associated with these
other domestic reforms, equity market liberalization still has a statistically
significant impact on growth.
The authors also break down the sample to examine those countries that have undertaken
more comprehensive domestic reform. The authors test the extent of such reform, in
combination with equity market liberalization, to better understand if the equity market
liberalization effect for these countries is greater than it is for those countries that
liberalize equity markets but do so with only minor domestic reforms in these other
areas. The authors find that for countries with a higher-than-average level of financial
development, the growth-enhancing benefits from equity market liberalization both add to
economic growth and provide a greater incremental effect relative to those countries
that started with below-average financial development and then liberalized. In addition,
countries that benefited the most from liberalization shared common attributes of
relatively better quality institutions and of relatively better investment environments,
thereby bringing a larger effect on growth from liberalization.
Lastly, the growth gap widens between those countries that undertake financial
liberalization and those that do not, with real GDP growing by an additional 2.2 percent
on an average annual basis for those countries that do liberalize.