Financial Openness and theFinancial Openness and theChinese Growth ExperienceChinese Growth Experience

Geert BekaertColumbia University and NBER

Campbell R. HarveyDuke University and NBER

Christian T. LundbladIndiana University

China at the Crossroads ConferenceAugust 29-30, 2005

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Financial Openness and China Plan

1. A Panel Perspective on China's Growth

2. Financial Openness and Growth

3. Empirical Results

4. Heterogeneity of Real Effects of Financial Openness on Growth

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Consumption Growth

Consumption Growth

Standard Deviation GDP Growth

GDP Growth Standard Deviation

Developed Countries 0.019 0.025 0.020 0.022Developing Countries 0.009 0.079 0.009 0.050Africa 0.003 0.090 0.003 0.057Asia 0.029 0.046 0.030 0.037Latin America 0.003 0.071 0.001 0.045China 0.070 0.044 0.078 0.027

Financial Openness and China Historical perspective

All real, per capita; not PPP-adjusted; from World Bank.

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Financial Openness and China Growth experience

GDP Growth

-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

1981

1982

1983

1984

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1986

1987

1988

1989

1990

1991

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1993

1994

1995

1996

1997

1998

1999

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2003

Developed Developing (ex. China) China

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Financial Openness and China Growth experience

Consumption Growth

-0.06

-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

0.12

0.14

0.16

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

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2003

Developed Developing (ex. China) China

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Financial Openness and China Growth volatility

GDP Growth Volatility(5-year rolling standard deviation)

0.00

0.01

0.02

0.03

0.04

0.05

0.06

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

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1994

1995

1996

1997

1998

1999

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2002

2003

Developed Developing (ex. China) China

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Financial Openness and China Growth volatility

Consumption Growth Volatility(5-year rolling standard deviation)

0.00

0.02

0.04

0.06

0.08

0.10

0.12

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

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2003

Developed Developing (ex. China) China

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Financial Openness and China Neoclassical Model

Barro (1991, 1992):

≠ growth accounting

, , , ,i t k i t i t i t kg Q Z GDPGrowth

ConvergenceEffect

Steady stateGDP determinants

, [Infrastructure (Real, Social, Human); Trade;

Financial Development; Institutions; Financial

Openness]

i tZ

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Financial Openness and China Model

Better measure to capture risk sharing benefits: idiosyncratic consumption growth volatility

where gi,t+k = k-period average of consumption growth for country i, xi,t and zi,t = control variables i = country; w=world = conditional variance of

)x(xγσ

)z(zλβ

ε)x(xgβg

w,ti,ti,t

w,ti,ti,t

ki,tw,ti,tkw,ti,tki,t

2

1

2i,tσ ki,tε

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Financial Openness and China Historical perspective

In late 1990s, Bekaert and Harvey begin a research program on financial openness

Time-lines constructed for• “Official” equity market liberalizations• ADR and Country Fund Launches• Capital account openness• Banking reforms• Privatizations• Capital Flows• FDI activity (to do)

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Chronologies also contain• Important political events

• Macroeconomic events

• Information on institutions

Currently, 56 emerging markets and over 400 pages of information

• http://www.duke.edu/~charvey/chronology.htm

Financial Openness and China Historical perspective

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Date YYMMDD

Event

901126 The Shanghai Securities Exchange reopened.a8

910409 The State Council adopted the Law Concerning the Income Tax of Foreign-Funded Enterprises and Foreign Enterprises and

eliminated a 10% tax imposed on distributed profits remitted abroad by the foreign investors in foreign-funded enterprises.a3

910426 The limit of daily price fluctuations increases from 0.5% to 1%.gk

910603 The stamp tax was decreased from 0.6% to 0.3%.gk

910926 "Regulations on Borrowing Overseas of Commercial Loans by Resident Institutions" and "Rules on Foreign Exchange

Guarantee by Resident Institutions in China" were issued.a3

910703 Shenzhen opened the country's second exchange.a8

9100 The "B" share came into existence. "B shares" can be owned by foreigners only, but they are afforded the same right of ownership as "A shares", which are reserved for Chinese nationals. In China, a share entitles the owner to a dividend

distribution, but not to a right to influence the operations of the company.jj

9203 The policy on foreign trade and investment was further liberalized, opening a large number of island and border areas to such

activities.a3

920521 Free stock price through free trading (less control of price formation). Shanghai index increases from 617 to 1266 on this

day.gk

921026 China Securities Regulatory Commission begins.gk

A Chronology of Economic, Political and Financial Events in China

Financial Openness and China Historical perspective

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• Decreased cost of capital• Changes might make country more sensitive to

world shocks• Impact on equity volatility not clear

=> Empirical work consistent with predictions

(Bekaert and Harvey (2000), Henry (2000), Kim and Singal (2000))

Financial Openness and China What are the financial effects of openness?

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• If cost of capital decreases, more projects NPV>0

• Investment increases

Financial Openness and China What are the real effects of openness?

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Financial Openness and China What are the real effects of openness?

Financial Development

Growth

Financial Liberalization

Relaxing FinConstraints

Investment

GrowthOpportunities

Efficiency ofInvestment

Cost of Capital

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• Liberalization implies consumption booms and inefficient investment (crisis literature)

• Liberalization may lead to reduced savings (endogenous growth literature)

• Liberalization may lead to “hot speculative capital” and induce capital flight (Stiglitz & others)

Financial Openness and China Sharply different views from literature…

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Financial Openness and China Previous research

• Bekaert-Harvey-Lumsdaine (Journal of Financial Economics, 2002)– Dating the integration of world markets

• Bekaert-Harvey-Lundblad (Journal of Financial Economics, 2005)– GDP growth positively impacted by financial openness

• Bekaert-Harvey-Lundblad (Journal of International Money and Finance, 2006)– Growth volatility does not increase, on average, after opening

• Bekaert-Harvey-Lundblad-Siegel (Working paper, 2005)– Growth opportunities linked to growth

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Financial Openness and China Previous research

• Bekaert-Harvey (Journal of Finance, 1995)– Model of time-varying world market integration (expected returns)

• Bekaert-Harvey (Journal of Financial Economics, 1997)– Model of time-varying world integration (expected returns; volatility)

• Bekaert-Harvey (Journal of Finance, 2000)– Financial openness impacts cost of capital, volatility, country’s sensitivity

to world events

• Bekaert-Harvey-Lundblad (Journal of Development Economics, 2001)– Econometric framework developed for panel growth regressions

• Bekaert-Harvey-Lundblad (Journal of International Money and Finance, 2002)– Capital flows, liberalization and the real economy

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Financial Openness and China Financial openness

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Financial Openness and China Financial openness

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Financial Openness and China Financial openness

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Financial Openness and China Results

Table 4

Growth PredictabilityAnnual Average Real Consumption and GDP Growth in excess of the World (Five-year horizon)1980-2003

Panel A EstimateStandard

Error Estimate Standard Error

Constant -0.0066 0.0020 -0.0058 0.0020Initial GDP -0.0077 0.0014 -0.0091 0.0012Log(Life Expectancy) 0.0843 0.0109 0.0975 0.0112Population Growth -0.1730 0.0887 -0.2851 0.1052Gov/GDP 0.0154 0.0149 -0.0078 0.0138Log(1+Inflation) 0.0011 0.0030 -0.0053 0.0027Trade/GDP 0.0064 0.0029 0.0071 0.0018Private Credit/GDP 0.0026 0.0026 0.0018 0.0030Financial Openness 0.0068 0.0023 0.0054 0.0029R2

Official Equity Market LiberalizationConsumption Growth GDP Growth

0.153 0.237

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Financial Openness and China ResultsTable 4

Growth PredictabilityAnnual Average Real Consumption and GDP Growth in excess of the World (Five-year horizon)1980-2003

Panel A EstimateStandard

Error Estimate Standard Error

Constant -0.0070 0.0022 -0.0067 0.0023Initial GDP -0.0083 0.0014 -0.0098 0.0011Log(Life Expectancy) 0.0876 0.0107 0.1003 0.0109Population Growth -0.1795 0.0862 -0.2809 0.1055Gov/GDP 0.0165 0.0147 -0.0071 0.0138Log(1+Inflation) 0.0011 0.0031 -0.0052 0.0028Trade/GDP 0.0067 0.0030 0.0078 0.0019Private Credit/GDP 0.0026 0.0027 0.0014 0.0032Financial Openness 0.0071 0.0023 0.0073 0.0030R2

Equity Market OpennessConsumption Growth GDP Growth

0.152 0.238

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Financial Openness and China ResultsTable 4

Growth PredictabilityAnnual Average Real Consumption and GDP Growth in excess of the World (Five-year horizon)1980-2003

Panel A EstimateStandard

Error Estimate Standard Error

Constant -0.0043 0.0016 -0.0058 0.0019Initial GDP -0.0101 0.0014 -0.0121 0.0012Log(Life Expectancy) 0.0878 0.0113 0.1032 0.0111Population Growth -0.3481 0.0818 -0.4842 0.0968Gov/GDP 0.0011 0.0143 -0.0220 0.0164Log(1+Inflation) 0.0016 0.0030 -0.0032 0.0027Trade/GDP 0.0041 0.0024 0.0065 0.0019Private Credit/GDP 0.0065 0.0023 0.0037 0.0029Financial Openness 0.0159 0.0038 0.0197 0.0036R2

Capital Account Openness (Quinn)Consumption Growth GDP Growth

0.176 0.297

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Financial Openness and China Components

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Financial Openness and China Financial development

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Financial Openness and China Decomposing the growth regression

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Financial Openness and China Decomposing the growth regression

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Financial Openness and China Components

Consumption/GDP

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Developed Developing (ex. China) China

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Financial Openness and China Components

Investment/GDP

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Developed Developing (ex. China) China

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Financial Openness and China Components(Exports-Imports)/GDP

-0.10

-0.08

-0.06

-0.04

-0.02

0.00

0.02

0.04

0.06

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

Developed Developing (ex. China) China

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Financial Openness and China Growth, Investment, and Total Factor Productivity

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Financial Openness and China Adding investment to growth regression

Reduces coefficient on private credit to GDP

Significant in consumption but not in GDP growth regressions

Raises predicted GDP growth by 0.4%

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Financial Openness and China Growth volatility

Table 7

Idiosyncratic Volatility PredictabilityAnnual Real Consumption Squared Growth Residuals1980-2003

EstimateStandard

Error

Constant 0.00071 0.00010Initial GDP -0.00005 0.00006Log(Life Expectancy) -0.00056 0.00046Population Growth 0.01509 0.00484Gov/GDP 0.00367 0.00162Log(1+Inflation) 0.00002 0.00023Trade/GDP 0.00048 0.00022Private Credit/GDP 0.00021 0.00014Financial Openness -0.00031 0.00015R2 0.069

Official Equity Market

Liberalization

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Financial Openness and China Growth volatility

Table 7

Idiosyncratic Volatility PredictabilityAnnual Real Consumption Squared Growth Residuals1980-2003

EstimateStandard

Error

Constant 0.00079 0.00011Initial GDP 0.00000 0.00006Log(Life Expectancy) -0.00071 0.00044Population Growth 0.01418 0.00483Gov/GDP 0.00366 0.00163Log(1+Inflation) 0.00000 0.00023Trade/GDP 0.00043 0.00023Private Credit/GDP 0.00027 0.00015Financial Openness -0.00052 0.00013R2 0.071

Equity Market Openness

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Financial Openness and China Growth volatility

Table 7

Idiosyncratic Volatility PredictabilityAnnual Real Consumption Squared Growth Residuals1980-2003

EstimateStandard

Error

Constant 0.00064 0.00008Initial GDP 0.00004 0.00006Log(Life Expectancy) -0.00173 0.00058Population Growth 0.01778 0.00496Gov/GDP 0.00104 0.00117Log(1+Inflation) 0.00007 0.00026Trade/GDP 0.00066 0.00016Private Credit/GDP 0.00016 0.00014Financial Openness -0.00007 0.00019R2 0.088

Capital Account Openness (Quinn)

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorPriv/GDP 0.00242 0.00252 0.00024 0.00014Fully Open 0.00881 0.00171 -0.00068 0.00012Low value 0.00101 0.00330 0.00007 0.00021High Value 0.01047 0.00425 -0.00032 0.00019

Mean Volatility

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorTurnover 0.00920 0.00268 0.00010 0.00011Fully Open 0.01021 0.00222 -0.00034 0.00009Low value -0.00651 0.00519 0.00012 0.00016High Value 0.00592 0.00406 -0.00027 0.00013

Mean Volatility

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Financial Openness and China Financial development

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorMCAP/GDP 0.00297 0.00286 0.00000 0.00009Fully Open 0.01064 0.00199 -0.00027 0.00007Low value -0.00314 0.00339 0.00043 0.00012High Value 0.00592 0.00398 -0.00050 0.00015

VolatilityMean

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Financial Openness and China Financial development

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorSocial Security 0.01909 0.00613 -0.00076 0.00035Fully Open 0.01017 0.00258 -0.00023 0.00009Low value -0.00570 0.00514 0.00012 0.00016High Value -0.00067 0.00351 -0.00015 0.00014

Mean Volatility

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorGov/GDP 0.01497 0.01494 0.00385 0.00166Fully Open 0.00886 0.00176 -0.00068 0.00012Low value 0.00211 0.00484 0.00013 0.00012High Value 0.00813 0.00273 -0.00032 0.00031

Mean Volatility

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorQuality of Inst. 0.01439 0.00655 -0.00202 0.00049Fully Open 0.00417 0.00166 -0.00024 0.00011Low value 0.00488 0.00338 0.00013 0.00026High Value 0.00192 0.00376 -0.00008 0.00019

Mean Volatility

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Financial Openness and China Country Risk

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Financial Openness and China Why do countries respond differently to openness?

Estimate Standard Error Estimate Standard ErrorInvestment Profile 0.04636 0.00856 -0.00053 0.00039Fully Open 0.00274 0.00195 -0.00059 0.00013Low value 0.00284 0.00337 0.00024 0.00023High Value 0.00133 0.00359 -0.00058 0.00023

Mean Volatility

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Financial Openness and China Country Risk

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Financial Openness and China Conclusions

China’s growth experience cannot be explained by standard growth models

Using standard growth determinants, China’s predicted growth in 2003 was 2.57% (versus 2.00% in 1980)

China is lower than average on:

• quality of institutions

• stock market development

• capital account openness

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Financial Openness and China Further research

Embed quality of institutions; finer measures of financial development in growth decompositions

Study factor productivity growth?

Study determinants of GDP per capita?

(see Roll and Talbot, 2004)

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Financial Openness and China Financial development

MCAP/GDP

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Developed Developing (ex. China) China

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Financial Openness and China Financial development

Equity Market Turnover

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Developed Developing (ex. China) China

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Financial Openness and China Financial development

Private Credit/GDP

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Developed Developing (ex. China) China

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Financial Openness and China Country Risk

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Financial Openness and China Country Risk

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Financial Openness and China Country Risk

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Financial Openness and China Country Risk

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Financial Openness and China Neoclassical Model

Consider the Solow (1956) model:

Y=A + K + (1-)L

where:Y = change in output per workerA = change in total factor productivityK = change in capital stockL = change in labor stockelasticity

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Figure 2

GDP Components: China

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

1980

1982

1984

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1988

1990

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2002

Consumption Investment Government Exports-Imports

Financial Openness and China Components

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Financial Openness and China Components

Government Consumption/GDP

0.00

0.05

0.10

0.15

0.20

0.25

1981

1982

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2003

Developed Developing (ex. China) China

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Financial Openness and China Components(Exports+Imports)/GDP

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1981

1982

1983

1984

1985

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1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

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1998

1999

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2003

Developed Developing (ex. China) China

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Financial Openness and China Components

Savings/GDP

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.50

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

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1994

1995

1996

1997

1998

1999

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Developed Developing (ex. China) China