Are financial development and trade openness complements or substitutes?

• Author: Kim, Dong-Hyeon

This article studies the long- and short-run relationships between financial development and trade openness. Using the pooled mean group estimator of Pesaran, Shin, and Smith (1999) for unbalanced panel data for 87 countries over the 1960-2005 period, our empirical results indicate that long-run complementarity between financial development and trade openness coexists with short-run substitutionarity between the two policy variables. But when splitting the data into OECD and non-OECD country groups, this finding can be observed only in non-OECD countries. For OECD countries, financial development has negligible effects on trade. In addition, we find nonlinearity in the relationship in that long-run responses of trade decrease with financial development. The article further finds coexistence of negative trade effects of financial fragility and positive trade impacts of financial depth.

JEL Classification: F13, G21

1. Introduction

   Recent theoretical literature on financial liberalization predicts that liberalization can generate both short-run financial instability and long-run economic growth. On the one hand, financial intermediaries and markets may produce information about profitable ventures, diversify risk, and facilitate resource mobilization. Thus, a well-developed financial system helps improve the efficiency of resource allocation and productivity growth, thereby promoting long-run economic growth. (1) On the other hand, financial liberalization may lead to undue lending booms, and hence financial crises, because of limited monitoring capacity of regulatory agencies, inability of banks to discriminate good projects during investment booms, and/or existence of an explicit or implicit insurance against banking failure. (2)

   More recently, Loayza and Ranciere (2006) provide cross-country evidence of coexistence of positive long-run and negative short-run relationships between financial development and growth. They link the negative short-run impact to financial fragility and the positive influence to long-run effects of financial liberalization. This article goes a step further and investigates whether such a dual role of financial liberalization results in heterogeneous long- and short-run responses of trade openness to financial development. If financial intermediation indeed affects trade openness, this might offer one mechanism through which financial development exerts its influence on long-run economic growth and short-run economic fluctuations.

   Several recent articles suggest that trade is strongly linked to financial development. (3) If greater international trade increases exposure to the fluctuations of the world goods market, the development of a financial system as an insurance mechanism might reduce barriers to trade. Feeney and Hillman (2004), for instance, demonstrate how capital market incompleteness can affect trade policy and that the degree of portfolio diversification determines the protectionist lobbying effort conducted by owners of sector-specific capital. If risk can be fully diversified, special interest groups have no incentive to lobby for protection, and free trade will prevail. Thus, the development of financial markets that mitigates informational asymmetries could lead to more trade liberalization and trade flows.

   Others emphasize that financial development is a source of comparative advantage. For example, Kletzer and Bardhan (1987) augment the Heckscher-Ohlin trade model by incorporating the financial sector and demonstrate that countries with a relatively well-developed financial sector have a comparative advantage in industries and sectors that rely more on external financing. Beck (2002) goes a step further and focuses on the role of financial intermediaries in mobilizing savings and facilitating large-scale and high-return projects. In the model, financial development lowers the search costs and increases the level of external finance in the economy. Banking development may thus shift incentives of producers toward goods with increasing returns to scale. Accordingly, the intersectoral specialization and the structure of trade flows are determined by the relative level of financial intermediation. All else being equal, economies with better-developed financial systems are net exporters of the goods with high scale of economies.

   In addition to the long-run effects, short-run considerations may play roles in the relationship. As suggested in the financial crisis literature, financial liberalization tends to cause financial fragility and hence financial crises and recessions in the short run. For example, Demirguc-Kunt and Detragiache (1998b) claim that financial liberalization erodes banks' monopolistic power, suggesting an increased moral hazard to banks with a low franchise value, thereby tending to make banking crises more likely. Daniel and Jones (2007) also reach similar conclusions. Van Order (2006) postulates that the fragility-provoked crises may have cyclical elements in that a downturn tends to lower asset values and/or twist the risk structure, adding more risky loans, which can provoke a crisis. Alessandria and Qian (2005) show that financial liberalization can lead to a lending boom and an aggregate shift toward worse projects, which often precede financial crises. In Stiglitz (2000) and Mishkin (2007a, b), financial liberalization, if carried out inappropriately, may induce destabilization in the financial system and trigger financial crises, thereby impeding economic performance. (4) Therefore, financial development as an insurance and comparative advantage contributor may generate more risks that impede international trade in the short run.

   Accordingly, econometric assessments of the finance-trade relationship should ideally be capable of uncovering the relevant long-run parameters as well as the short-run link between the two variables. Therefore, this article revisits the issue and estimates the long- and short-run relationship between financial development and trade openness by using panel techniques that explicitly isolate trend effects of financial development from short-lived considerations. This can be accomplished by specifying an autoregressive distributed lag (ARDL) model for each country, pooling them together in a panel, and then testing the cross-equation restriction of a common long-run relationship between the two variables using the pooled mean group (PMG) estimator of Pesaran, Shin, and Smith (1999). Such a country-specific ARDL approach allows us not only to accommodate cross-country heterogeneity (for example, in the degree of credit market imperfections and policy regimes), but also to capture certain interesting time-series relations that cross-section analysis alone cannot deal with. Moreover, this methodology can be applied to either stationary or nonstationary variables and does not require the pretesting of unit roots. This partially circumvents some of the problems with cointegration analysis that focuses only on the estimation of long-run relationship among I(1) variables, as well as low power of unit root tests against plausible alternatives. Further, instead of averaging the data per country to isolate trend effects, (5) both long- and short-run relationships are estimated using a panel of data pooling time-series and cross-section effects. (6)

   Using panel data pooled from 87 developed and developing countries for the 1960-2005 period, we find evidence of a strong link between financial development and trade openness. While financial development is detrimental to trade openness in the short run, it ultimately contributes to trade openness in the long run. In other words, trade openness and financial development are substitutes in the short run but complements in the long run. This may partially explain why the effects of financial development on growth differ in different time horizons. However, when splitting the data into OECD and non-OECD country groups, we find interesting results. In non-OECD countries, a positive long-run relationship coexists with a negative short-run link. But financial development does not exert significant effects on trade liberalization in OECD countries. This suggests that the long-run effect of financial development on international trade decreases with financial development. We also find that financial development tends to have a significant and negative short-run impact in medium-financial-development countries with the effect insignificant for both high- and low-financial-development countries. Finally, the article provides evidence that the short-run negative responses of trade to finance are mainly due to financial fragility, while the positive effects of finance on trade are largely due to financial deepening.

   The remainder of the article is organized as follows. Section 2 introduces the PMG estimator proposed by Pesaran, Shin, and Smith (1999). Section 3 describes the data and source and analyzes various empirical results by the PMG approach. Section 4 assesses whether financial fragility is also relevant in the relationship, and section 5 concludes.

2. The Autoregressive Distributed Lag Approach

   To examine the effect of financial development, Beck (2002, 2003) and Svaleryd and Vlachos (2002, 2005) estimate the following cross-sectional regression:

   [trade.sub.i] = [alpha] + [beta] [finance.sub.i] + [omega] [controls.sub.i] + [[epsilon].sub.i], (1)

   where i = 1, 2, ..., N is the country indicator, trade is the trade openness index, finance is the financial development indicator, controls is a set of control variables, and e is the error term.

   As an alternative, this article investigates the effect of finance on trade using dynamic panel econometric techniques. In particular, Equation 1 is extended to a panel data specification, assuming that there exists a long-run relationship between trade and finance:

   [trade.sub.it] = [[alpha].sub.i] + [beta] [finance.sub.it] + [omega]...