Open Equity Markets Raise Growth

If one examines economic growth in emerging markets before and after financial market liberalization, the results suggest that financial market liberalizations are associated with higher real growth.

The world's emerging markets--countries aggressively seeking a firmer foothold in today's global economy--frequently get three words of advice about how to accelerate economic growth: reform, reform, reform. Policymakers are told that establishing a framework for long-term economic health requires changes that, among other things, reduce government spending, lower trade barriers, and make financial markets more attractive to foreign investment. But given that any reform-related gains likely will involve at least some reform-induced pain, what sort of assurances can be offered to these transitioning economies that, despite the political obstacles, a payback is in the offing?

NBER Research Associates Geert Bekaert, Campbell Harvey, and co-author Christian Lundblad argue that, at least when it comes to financial liberalization, there is strong evidence that reforms lead to tangible rewards. They find that when emerging market countries enact policies to for example, open up equity markets to foreign investors, they experience a one to two percent annual increase in economic growth.

Their study, Emerging Equity Markets and Economic Development (NBER Working Paper No. 7763), stops short of claiming a direct cause and effect relationship between financial liberalization and growth. But what they can say is that if one examines economic growth in emerging markets before and after financial market liberalization, the "results suggest that financial market liberalizations are associated with higher real growth."

For example, when the authors examine 21 countries that dropped barriers to foreign participation in equity markets, "17 exhibit larger average growth rates after the official liberalization dates." Further, "A reduction in the cost of capital and/or an improvement in growth opportunities are the most obvious channels through which financial liberalization can increase economic growth," the authors state.

Bekaert, Harvey, and Lundblad are aware that some might challenge their conclusions as failing to consider the fact that, for many emerging market countries, financial reforms are enacted in close proximity to other reforms--such as those that address trade and government spending -- all of which have the potential to improve economic performance. Indeed, the authors acknowledge that "the shortcoming of exploring the changes in real economic growth before and after financial liberalization is that the observed change may be related to various economic and political phenomena" that have nothing to do with financial reforms.

To account for this potential distortion, Bekaert, Harvey, and Lundblad engage in a complex bit of analysis that seeks to isolate the effect of financial liberalization from other reform-related improvements, including reduced government consumption, increased trade, lower inflation, and higher levels of secondary school enrollment. This calculation produces a somewhat lower figure for the impact of financial liberalization on growth, but a tangible gain still emerges.

For example, without considering other factors that might also boost growth, the study found that financial liberalization leads to an increase in average annual per capita GDP growth of "anywhere from 1.5 percent to as large as 2.3 percent." But what's "striking," say the authors, is that even when they factor in a host of other variables that might also boost economic performance, improvements associated with financial liberalization, while they drop to anywhere from .7 to 1.4 percent, remain strong. Interestingly, they find that the liberalization effect on growth is particularly strong for countries with higher levels of secondary school enrollment.

Until there is further study of the issue, Bekaert, Harvey, and Lundblad will only label their results as "intriguing," not conclusive. For example, they believe more work needs to be done to pinpoint the effect of financial liberalization on capital costs and investment activity. Such an analysis--which they are undertaking in ongoing work --could determine precisely how these reforms fuel broad economic gains.

-- Matthew Davis