INTERACTIONS BETWEEN FINANCIAL DEVELOPMENT AND TRADE OPENNESS
| DOI | http://doi.org/10.1111/j.1467-9485.2011.00559.x |
| Date | 01 September 2011 |
| Author | Dong‐Hyeon Kim,Shu‐Chin Lin,Yu‐Bo Suen |
| Published date | 01 September 2011 |
INTERACTIONS BETWEEN FINANCIAL
DEVELOPMENT AND TRADE OPENNESS
Dong-Hyeon Kim
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, Shu-Chin Lin
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and Yu-Bo Suen
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Abstract
This paper empirically investigates the interaction between financial develop-
ment and trade openness through simultaneous-equation systems. The identifica-
tion and estimation of the systems rely on the methodology of identification
through heteroskedasticity proposed by Rigobon (2003). Using a panel consisting
of 70 countries over the period 1960–2007, we find a two-way causal relationship
between financial development and trade openness. A better-developed financial
sector induces higher openness to trade, while higher openness in goods market
stymies financial development. And such findings hold well for low-income, high-
inflation, or low-governance countries.
I Intro ductio n
This paper explores two-way interactions between financial development and trade
openness. We seek to understand whether trade liberalization contributes to the
functioning of financial systems and whether a better-developed financial sector
accelerates the pace of goods market openness. The issue is of a crucial importance
not only because both financial development and trade openness are central
matters in economic policy but also because identifying the link between trade and
finance helps clarify economic growth. On the one hand, if increasing trade
openness leads to an increase in financial development, this may promote
economic growth where finance is found to enhance growth via the allocative and
accumulative channels. On the other hand, if finance induces openness, it may
subsequently foster growth where openness is found to be a driving force of
economic growth through specialization, scale economies and technology transfers.
In the literature, links between trade and financial development may take
different forms. On the one hand, trade openness may induce development in
financial markets. In Rajan and Zingales (2003), trade opening, especially when
combined with openness to capital flows, weakens the incentives of incumbent
industrialized firms or financial intermediaries to block financial development in
n
Sungshin Women’s University
nn
Tamkang University
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Aletheia University
Scottish Journal of Political Economy, Vol. 58, No. 4, September 2011
r2011 The Authors. Scottish Journal of Political Economy r2011 Scottish Economic Society. Published by Blackwell
Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
567
order to reduce entry and competition. Furthermore, the relative political power
of incumbents may decrease with trade as well. Thus, trade has a beneficial
impact on financial development. Braun and Raddatz (2005, 2008) explore this
political channel further and demonstrate that countries in which trade
liberalization reduces the power of groups most interested in blocking financial
development observe an improvement in the financial system. However, when
trade opening strengthens these groups, external finance suffers. From a
different view, Do and Levchenko (2004, 2007) argue that financial development
is endogenously determined in part by demand for external finance and hence by
comparative advantage of each country. Countries specializing in financially
dependent goods will have a high demand for external finance and thus a high
level of financial intermediation. In contrast, the financial system will be less
developed in countries that specialize in goods relying less on external finance.
On the other hand, financial development may be initiated by trade openness.
Feeney and Hillman (2004) demonstrate that the degree of portfolio diversification
determines protectionist lobbying efforts conducted by owners of sector-specific
capital. If risk can be fully diversified, special interest groups have no incentive to
lobby for protection. Thus, the development of financial markets as an insurance
mechanism maylead to higher trade openness. In Kletzer andBardhan (1987) and
Beck (2002), maturefinancial markets may constitute a comparativeadvantage for
industrial sectors that rely heavily on external financing. Thus, economies with
developed financial systems are expected to feature industrial and trade structures
that are linked to finance-dependent sectors of the economy.
Further, trade and finance may be mutually dependent. As put forth in
Svaleryd and Vlachos(2002), if trade restrictions aim to insuredomestic industries
against swings in worldmarket prices, the development of financial markets could
lead to trade liberalization which, in turn, could lead to the development of
financial markets that help agents diversify the added risks. Trade and finance
may also evolve independently of each other,so no causality exists between them.
As put forth in Rajan and Zingales (2003), a country opens to trade when it sees
opportunity, yet it is also likely to be a time that financial markets expand. A
correlation between trade openness and financial markets may simply reflect a
common driving force (opportunity) rather than a causal relationship.
Therefore, empirical studies based on single-equation regressions are subject
to reverse causality and endogeneity bias.
1
In this respect, this paper intends to
make a contribution to the literature by providing empirical relevance to the
finance-trade nexus through simultaneous-equation model (SEM) in which the
1
For example, by regressing financial development measure on trade openness indicator
along with other controls, Rajan and Zingales (2003), Law and Demetriades (2005), Huang and
Temple (2005), Do and Levchenko (2007), Baltagi et al. (2009) and Kim et al. (2010a) find
evidence in support of a positive effect of trade on financial development. On the other hand, in
a regression of trade indicator on financial development measure as well as other controls,
Svaleryd and Vlachos (2002, 2005), Beck (2002, 2003), Hur and Raj (2006), and Kim et al.
(2010b) show that firms in countries with well-functioning financial sector enjoy easier access to
external finance than those without, and tend to specialize in industries that are more dependent
on external finance. These studies control for simultaneity problem but fail to address the
reverse causation issue.
D.-H.KIM,S.-C.LINANDY.-B.SUEN568
Scottish Journal of Political Economy
r2011 The Authors. Scottish Journal of Political Economy r2011 Scottish Economic Society
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