Impact of Financial Liberalization on Current Account with Complementary Effect of Institution: A Global Evidence

Abstract

Financial Liberalization in recent years is seen as a driver of economic growth. However, at the same time, many authors have argued that free capital mobility produces macroeconomic instability and contributes to financial vulnerability in emerging nations. For example, Stiglitz (2002) has argued that pressuring emerging and transition countries to relax controls on capital mobility during the 1990s was a huge mistake. The questions remain why some countries benefit from liberalization while some do not. We proposed that governance institutions may be the deciding factor in this regard. Where institutions' quality is weak, most of the foreign investment would be opportunistic and short term in nature, hence would huge outflows later on after liberalization. However, in the case of strong institutions, the investment would be in long term Greenfield projects, leading to sustainable returns. In this way surplus funds would be reinvested, relieving the pressure from the current account in the long run. To establish its empirical validity, an econometric analysis was performed, using data of 50 countries (40 developing) from 2009 to 2018. KAOPEN (Capital account openness based on IMF’s Exchange Arrangements and Exchange Restriction) was used as a proxy for financial liberalization along with institutions (WGI), and their impact on Current account (CA) was assessed using other variables like Inflation (CPI), Trade Openness (exports and imports as % of GDP), financial development (Deposit to GDP), and real GDP as control. The results suggested that liberalization seems to have a negative but insignificant effect on the Current account. Whereas, Institutions have a significant and positive effect. However, the interaction effect showed a negative complementarity of institutions in liberalization and CA relationship. This implies that strong institutions not only promote CA inflow ever in the long run but also decrease the effect of legalization on CA, meaning if the effect is negative, institutions would decrease its severity. Other interesting findings suggested that financial development has a negative and significant effect on CA. Hence, institutions seem to act as a crucial factor in solving the liberalization puzzle, and developing countries should make their governance institutions strong before opening up to the world.

Keywords: Financial Liberalization, Trade openness, Current Account, Financial Deepening, KAOPEN, Inflation