Trade Liberalization and the Politics of Financial Development Trade Liberalization and the Politics of Financial Development

January 10, 2011

Motivation for the Research
It has been extensively documented that the level of financial development, however measured, varies greatly across countries. However, the ranking of countries varies through time. Our theories of financial development need to explain both the relatively high persistence in degree of financial depth as shown in key indicators and the non-trivial changes in the ranking across countries at different moments in time. Existing theories-which rely on stable and largely predetermined institutional features-successful as they are in explaining the cross-sectional

Research Approach
This paper builds on the premise that a well-developed financial system enhances competition in the industrial sector by allowing easier entry. The authors document this fact by showing that both aggregate manufacturing-sector price-cost margins and average firm size-representing measures of incumbents' rents or the inverse of the degree of competition in an industry-are significantly negatively correlated with financial development across countries. They show, however, that there is important heterogeneity in

The authors split industries into two equal-sized groups, according to whether the benefits of easier access to external finance outweigh the costs of increased competition, and call them the promoters and opponents of financial development, positing that the relative strength of each group determines the equilibrium level of financial system sophistication. Absent significant perturbations to this political economy equilibrium, they do not expect significant changes in financial development.

Trade liberalization is a perturbation to the relatively high persistence of private credit. The paper uses an event study and regression analysis to study the change induced by trade liberalization in the relative strength of promoters across 41 trade-liberalizing countries to see whether this is a good predictor of subsequent financial development.

Key Findings

  • The change in the relative strength of promoters induced by trade liberalization is a very good predictor of subsequent financial development.
  • Evidence suggests that the relation between changes in relative strength of promoters and subsequent financial development is mediated by policy adjustments-especially adjustments to policies that induce change in the financial sector-made in the five-year period following trade liberalization.
  • By overcoming informational and agency problems, a well-functioning financial system can foster growth through two main channels: by increasing resources available for investment and by better allocating these scarce funds. The results provide some indication that it is allocation that is the more affected.
  • The effects of trade liberalization are particularly strong in countries with relatively high levels of governance, suggesting that incumbents resort to this costly but more subtle way of restricting entry when the degree of governance would make it difficult to obtain more blatant forms of anti-competitive measures from politicians.

Although deep institutional reasons play a role, to an important extent countries have the level of financial development they choose. Policy convergence to best-practice standards is not likely to happen automatically unless the political-economic conditions for such a change are present.

Policies that on average have a liberalizing effect on markets are not by themselves enough to guarantee their extension to the financial system. They can even worsen the situation. In this context, understanding the interrelation between sectoral reforms and adjusting the timing accordingly seems of first-order importance.

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