Ready For Capital Account Convertibility

Journal of International Money and Finance 28 (2009) 10061021
Contents lists available at ScienceDirect
Journal of International Money

and Finance
journal homepage: www.elsevier.com/locate/jimf
Ready for capital account convertibility?

Purba Mukerji*
Department of Economics, University of San Francisco, 2130 Fulton Street, San Francisco, CA 94117, USA
a b s t r a c t
JEL classication:
F30
F43
Keywords:
Volatility
Capital account convertibility
Financial development
This paper investigates whether the impact of capital account

convertibility on the long term volatility of economic growth
depends on nancial development. It estimates a system of three
simultaneous equations: mean growth, volatility of growth and
nancial development. This allows for the study of both, the
impact of capital account liberalization on volatility, as well as its
direct impact on nancial development. Results indicate that
economies with low nancial development fall prey to excess
volatility arising from capital account openness, while capital
account openness itself has a signicant positive impact on
nancial development. The results are robust to alternative
measures of nancial development and volatility and to the
removal of outliers.
2008 Elsevier Ltd. All rights reserved.
1. Introduction
The history of international capital ow dates back to the 19th century, when the global capital
market linked nancial centers all over the world. The world wars and the great depression saw
a considerable reduction in these ows as countries restricted cross border capital movements through
controls on their capital account (Obstfeld, 1998). The current round of capital account liberalization
dates back to the sixties in some industrialized countries and the early seventies in parts of the
developing world. Table 1 presents a time-line of liberalization in 31 developing countries, as per the
International Monetary Fund indicator of capital account openness. While the table lists some
developing countries that have already allowed relatively free cross border capital ows, there are
several others that are yet to make this transition. Over the past four decades as more countries have
* Tel.: 1 (202) 294 2037; fax: 1 415 422 6983.

E-mail address: purbamukerji@gmail.com
0261-5606/$ see front matter 2008 Elsevier Ltd. All rights reserved.
doi:10.1016/j.jimonn.2008.10.001
P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021
1007
Table 1
Countries with no restrictions on the capital account transaction as per IMF classication (Source: International Monetary Fund,
19701999. Annual reports on exchange arrangements and exchange restrictions).
Country
Period without restriction
Argentina
Australia
Bolivia
Botswana
Canada
Costa Rica
Denmark
Ecuador
Fiji
The Gambia
Guatemala
Honduras
Hong Kong
Indonesia
Islamic Republic of Iran
Liberia
Malaysia
Mexico
Nicaragua
Niger
Panama
Paraguay
Peru
Seychelles
Singapore
Switzerland
Togo
United Kingdom
United States
Uruguay
Republic of Yemen
19681970, 19941996
19841995
19671981, 19871999
19661967, 19981999
19661995, 19971999
19661970, 19731974,
19881995, 19971999
19671970, 19721993,
19661970
1968, 19921996
19741980, 19901999
19671980
19671999
19701996
19751978
19671984
19741999
19671982
19671978, 19971999
1996
19671996, 19981999
19831984, 19971999
19661969, 19791984,
19661996, 19981999
19791996
19661999
1967, 1995
19791999
19661999
19661967, 19791993,
19731990
19811982, 19951996, 19981999

1995
19941999
19971999
joined the ranks of those with capital account convertibility, their experiences with free capital
mobility into and out of their economies yield valuable lessons for others considering this move.
World experience has made it evident that the success of the decision to liberalize depends critically
on its timing; the economy must be ready to handle the consequences and reap the benets of capital
convertibility. However, in the past, particularly before the Asian nancial market crisis of the late
1990s, relatively less attention was paid to the readiness of individual economies based on their
particular stage of development. Policy makers broadly agreed that capital account openness was
desirable for all countries simply because most developed countries had it. While the International
Monetary Fund (IMF) did attempt to incorporate some country specic factors when advising developing members on capital account liberalization, this exercise was mostly ad-hoc and not uniformly
undertaken in all cases (report on the evaluation of the IMFs approach to capital account liberalization,
2005). The timing of liberalization turns out to be crucial, even though policy makers have underestimated its importance. This is no surprise considering the unique issues that relate to trade in capital
among countries.
There are several potential benets of capital mobility: it allows allocation of resources to the most
productive use; investors are able to diversify their portfolios and earn a higher risk adjusted rate of
return; and investable funds are made available in developing countries. International nancial
liberalization provides incentives for accelerated reforms of domestic nancial markets and institutions (Kaminsky and Schmukler, 2003). Moreover, international capital markets tend to enforce
discipline (Fischer, 1998).
At the same, there is a downside to liberalization. Reinhart and Tokatlidis (in press) nd that most of
the benets of liberalization occur only in high income countries. An open capital account brings the
1008
risk of volatility due to both the lack of information as well as the lack of incentive for gathering
information, causing foreign investors in emerging markets to exhibit herd behavior (Calvo, 1999). Lack
of knowledge leads international investors to show limited condence in emerging markets. All the
same in times of boom many such markets can receive tremendous amounts of capital inows. This
automatically puts them at risk from sudden reversal of investor sentiment. Irrespective of whether
investors base their decision on the fundamentals of the economy or simply exhibit herd behavior, the
chaos and contraction that follows when investors suddenly lose condence in a market and abruptly
exit is very real.
The evidence from this work indicates that the stage of nancial development inuences the
readiness for open capital markets most profoundly. The logic is straightforward. Financial development provides domestic economic agents the ability to borrow relatively easily in troubled times even
as their net worth is declining (Aghion et al., 2000). This prevents excessive volatility in the economy
that might otherwise result from a sudden pull out by international investors.
This paper attempts to test the hypothesis that the impact of capital account liberalization on the
volatility of economic growth depends on the level of nancial development. New evidence in this
paper indicates that there is a differential effect of capital account openness: higher nancial development helps an economy to handle capital account convertibility better in the sense that convertibility does not lead to excessive uctuations. The paper nds that capital account openness tends to
promote nancial development directly. Using a simultaneous equations set-up where we model
volatility, nancial development and growth explicitly, we are able to clearly highlight this real-world
policy tradeoff. The empirical results obtained in this work are robust to alternative measures of
nancial development and volatility, and to the removal of the top and bottom 10% countries in terms
of per capita gross domestic product of the sample.
This paper goes beyond previous studies in the following important ways. First it studies the impact
of capital account liberalization on volatility of economic growth and allows this impact to vary with
nancial development. Second, it addresses the questions of endogeneity and causality that arise in
this context by using three simultaneous equations, one each for volatility, economic growth and
nancial development. This allows explicitly for previously well-documented links between these
variables and for liberalization to impact the level of nancial development itself, thus providing the
means to address important policy trade-offs directly. Third, it proposes dispersion of growth rates
among sectors of the economy as a new instrument for nancial development. The intuition is derived
from Patrick (1966), where a larger gap between leading and lagging sectors creates a greater incentive
for nancial development in order to shift resources from one to the other.
2. Literature review
Empirical investigation of capital account liberalization has focused mostly on its impact on mean
growth and has yielded conicting results (Eichengreen, 2001). Rodrik (1998) found that capital
account liberalization has an insignicant effect on growth rates. He used the International Monetary
Fund indicator to measure capital account openness. Quinn and Inclan (1997) constructed and used
a nuanced measure of capital controls, and found a signicant positive impact of having a more open
capital account. Edwards (2001) using the Quinn measure found that having a liberal capital account
regime has a positive impact in rich countries but a negative impact in poor countries.
Theoretical literature and anecdotal evidence, however, suggest another important route through
which capital account convertibility impacts an economy volatility. And volatility in an economy
matters a great deal since its burden falls disproportionately on the poor. In a model of a small open
economy Aghion et al., 2000 show that in economies at an intermediate level of nancial development,
full nancial liberalization in the sense of opening the domestic market to foreign capital ows may
destabilize the economy. Other theoretical models link low levels of nancial development with
volatility in economies (Paasche, 2001; Cespedes et al., 2000) and closed economies (Bernanke and
Gertler, 1989; Kiyotaki and Moore, 1997).
This work uses an empirical model to test the hypothesis that that differences in nancial development lead to different impacts of capital account liberalization. In order to address the concern that
some of the contradicting results are due to differences in samples, this work uses the widest sample of
1009
countries and time periods of all the aforementioned studies. The empirical model developed in this
paper allows for simultaneous determination of volatility, economic growth and nancial development, and allows for important links between them. These links have been discussed widely in the
literature. In cross-country data, Ramey and Ramey (1995) nd that countries with higher volatility
have lower average growth. In addition, King and Levine (1993) present cross-country evidence that
nancial development is strongly associated with growth. Patrick (1966) discusses the causal relationship between nancial development and economic growth.
Past work on the determinants of volatility (Easterly et al., 2000; Denizer et al., 2002) has found that
nancially developed countries experience less uctuations. This paper adds an important international dimension to these by considering the role of international capital ows and spillover effects.
Bekaert et al. (2006) nd the effect of equity market liberalization and capital account openness to
be mostly associated with lower consumption growth volatility in developed countries and, quite
surprisingly, not to be associated with any signicant change in volatility in emerging markets. This
study nds the same trends in the growth volatility of developed countries but nds the opposite in the
case of emerging markets with low levels of nancial development. The positive feedback effect that
liberalization has on nancial development is a probable reason for this contradiction (Kaminsky and
Schmukler, 2003; Fischer, 1998). This effect could be especially pronounced in emerging markets. The
empirical model developed in this study captures this separate effect explicitly thereby highlighting
the complex nature of the relation between nancial liberalization and volatility which plays out in the
context of prevailing nancial conditions where these nancial conditions are in turn are impacted by
the decision to liberalize.
3. The model
The empirical model developed in this study consists of a system of three simultaneous equations
(Eqs. (1)(3)). The equations represent volatility, economic growth and nancial development,
respectively. The model helps in answering the central question of whether the impact of capital
account convertibility on volatility depends on nancial development, while at the same time
accounting for important relationships and linkages that arise in that context. We model three
simultaneous equations because a complete answer to the question of whether the impact of capital
account openness depends on the level of nancial development requires us to clearly take into
consideration both the impact of the capital account volatility as well its impact on nancial development itself.
Therefore the purpose of having a separate nancial development equation is the nature of policy
recommendations that this paper seeks to make and the past literatures seemingly contradictory
signals on this issue. Specically there are two distinct views on capital account liberalization, one that
suggests a cautionary approach since the outside world has a huge impact on the outcomes of such
a move especially in emerging markets (Calvo et al., 1996) and the other that suggests that too much
caution may prevent a nation from reaping the benets of market competition and discipline that
capital account openness imposes (Kamisky and Schmukler, 2003). Having an explicit nancial
development equation helps us to untangle these views by giving us an explicit measure of the impact
of capital account openness on nancial development and volatility via its coefcients in those two
regression equations. Our results indicate that while capital account liberalization promotes nancial
development, it also leads to excessive volatility unless the country is sufciently nancially developed
to begin with. This helps to attenuate the argument of those that suggest a fast track transition to
capital account liberalization while also recognizing the cost of over caution. In sum, our policy
recommendations take a comprehensive view of the capital accounts impact on the domestic
economy. In this context having a separate explicit equation for nancial development is indispensable.
There is other literature that suggests the importance of having an explicit equation for growth: there
is a long list of theoretical and empirical work that suggests a positive relationship between economic
growth and nancial development (King and Levine, 1993; Patrick, 1966; Greenwood and Jovanovic,
1990; Greenwood and Smith, 1997) and a literature that suggests volatility has a negative impact on
growth (Ramey and Ramey, 1995; Mobarak, 2005) and might in turn be inuenced by it. The potential
positive inuence of growth on political stability is an example of this (Londregan and Poole, 1989).
1010
The volatility equation that we estimate is thus interrelated with other equations in the more
complete model. Volatility itself has been found to be inuenced by nancial development (Denizer
et al., 2002; Easterly et al., 2000; Aghion et al., 2000). We focus on the impact of the level of nancial
development and capital account openness on volatility in this paper. In addition we test for the impact
of the capital account regime and spillovers from trade channels on volatility.
The estimated system is as follows: all independent variables (except the identifying restrictions)
enter all equations simultaneously.

Vi;t a0 at a1 Ki;t a2 Fi;t a3 Fi;t Ki;t a4 Gi;t a5 Wi;t V:;t X1i;t a6 31i;t ;
(1)
Gi;t b0 bt b1 Ki;t b2 Fi;t b3 Vi;t b4 Wi;t G:;t b5 Wi;t V:;t X2i;t b6 32i;t ; and
(2)
Fi;t g0 gt g1 Fi;t1 g2 Ki;t g3 Gi;t X3i;t g4 33i;t ;
(3)
where Vi;t volatility (standard deviation) of the growth rate in country i during the decade t.
Gi;t mean annual growth rate of real gross domestic product per capita in country i during time
period t, Fi;t a measure of average nancial development of country i in decade t. Ki;t an index of the
capital account openness of country i, constructed as the average annual International Monetary Fund
(IMF) dummy (01) over decade t. The index is re-scaled such that zero signies the maximum control
and unity the least. Wi;t V:;t ; Wi;t G:;t spatial lags, calculated as the weighted average of a countrys
major trading partners growth and volatility, are used to account for spillovers. t 1 for the decade
19601969, t 2 for 19701979, t 3 for 19801989, and t 4 for 19901999. at ; bt and gt controls
for decade xed effects. X1, X2, and X3 in Eqs. (1)(3) are vectors of independent explanatory variables.
To test for differential inuence of capital account convertibility on the volatility of an economy
depending on its level of nancial development, the volatility equation (Eq. (1)) looks for the inuence
of capital account convertibility Ki;t , as well as the interaction term between capital account
convertibility and nancial development Fi;t Ki;t . Theory suggests that the volatility increasing
impact of capital account liberalization diminishes as nancial development increases, which implies
a negative signicant coefcient a3 , on their interaction term.
Fi;t is measured as the average of the ratio of credit to the private sector over gross domestic
product, in decade t. Credit to the private sector refers to nancial resources provided to the private
sector such as through loans, purchases of non-equity securities, trade credit and other accounts
receivables that establish a claim for repayment. This is one of the measures used in the King and
Levine (1993) paper that is chosen because it accounts for one of the most important functions of
the nancial structure: channeling savings into the productive sectors of the economy. In addition,
sensitivity tests presented later show the empirical results of this work robust to alternative
measures of nancial development.
The data for Ki;t is obtained from IMFs annual reports on exchange arrangements and exchange
restrictions. Countries with capital controls are classied by the IMF as having restrictions on
payments for capital transactions. The decision to model it as exogenous is based on empirical and
theoretical literature that suggest that capital account liberalization is often not linked with the
fundamentals of the domestic economy. The existence of a very wide range of levels of capital account
liberalization in countries at fairly comparable stages of development lends credence to the fact that it
is likely that predominantly outside forces determine the timing of capital account liberalization.
Argentina phased out all capital controls by the 1980s. Thailand on the other hand only liberalized in
the early 1990s and India is still contemplating the pre-requisites of the move to capital mobility!
Capital account liberalization has taken place in several countries, especially in the developed ones in
the natural course of the economys evolution (Eichengreen, 2005). Even among developed nations,
while the United States was a pioneer in this liberalization, several others such as Austria, Denmark,
Finland, Norway and Sweden, didnt liberalize until the 1990s. Some have been encouraged to liberalize
by the IMF, these recommendations were largely ad-hoc in nature and not based on particular
1011
conditions of the economy in question (International Monetary Funds Report on the Evaluation of the
IMFs Approach to Capital Account Liberalization, 2005). Conditions in foreign markets: competition
among emerging markets for funds, low interest rates in developed countries, copying policies of
neighboring countries etc. have led still other countries to liberalize at different points over the past
few decades (Calvo et al., 1996; Bartolini and Drazen, 1997; Bacchetta and Wincoop, 1998; Simmons
and Elkins, 2000). Given this evidence the literature has largely chosen to assume capital account
openness to be exogenous particularly for the purpose of studying its impact in cross-country studies.
Wt is an N N weighting matrix that consists of average trade shares, over the decade, of the top 20
trading partners of each country in the sample. Each row has the trade shares of all the trade partners
of one country. The ith row, Wi;t , corresponds to shares of the ith countrys trade, that its major trade
partners account for. It must be noted that the ith row has a zero as its ith element since no country is
considered its own trade partner. In addition, zero also corresponds to a country that is not a major
trading partner of country i. Wt therefore serves as a selector matrix that selectively weighs only those
countries which are major trade partners of the particular country whose spatial lag is being calculated.
Wi;t Y:;t refers to the spatial lag for country i in time t. Wi;t is the ith row of the Wt matrix and so it
contains the trade weights of each trading partner of country i. Y:;t refers to the vector of volatility or
growth of all countries in the sample at time t. The product of Y:;t and Wi;t leads to the weighted average
of country is trading partners volatility or growth at time t.
The rationale for including the spatial lag terms is that globalization has led to ever closer links
among countries. There is ever growing evidence of co-movement across economies which cannot be
explained by economic fundamentals alone (Moreno and Trehan, 1997; Easterly, 1996; Eichengreen
et al., 1996; Bacchetta and Wincoop, 1998). Two spatial lags are represented in the empirical model. The
spatial of growth appears in the growth equation and is the weighted average of growth rates in
a countrys top trading partners. This term captures the spillover of growth among trade partners
which impacts the domestic economy beyond any direct impact on economic fundamentals. The
spatial lag of volatility measures the weighted average of trade partners volatility and appears in both
the growth and volatility equation, given that volatility of trade partners may quite easily directly
impact the volatility as well as growth of an economy. Since we are interested in capturing long term
relationships with data spanning four decades, the use of trade linkages as the channel for spillovers
appears to be appropriate.
In order to standardize the model in the context of the simultaneous equations framework, all the
independent variables, besides the exclusion restrictions (discussed in Section 4) enter all the equations simultaneously; thereby putting the least possible constraints on the data. Table 2 presents the
list of independent variables that appear in the model. The data is cross-country panel for four decades
starting in 1960 going up to 1999. Using decade averages implies the sample from 1960 to 1999 yields
four time periods. We are following previous empirical literature on cross-country regressions
involving volatility estimations over similar time periods which have settled on approximately decadewise division of the dataset (Denizer et al., 2002; Mobarak, 2005). This recognizes the tradeoff
involved: the larger the number of years in one time period the better is the accuracy with which we
are able to capture the business cycle uctuations while making our time xed effects calculations less
efcient. Decade specic panel allows us to estimate volatility over a fairly large number of years and
still have 4 time periods.
4. The exclusion restrictions
The system contains exclusion restrictions to instrument for the endogenous variables and based on
theoretical and empirical priors. Volatility is instrumented using a dummy variable for diversied
exporters1 and the interaction of capital account openness with the level of nancial development.
Growth is instrumented by the ratio of initial investment to gross domestic product, initial secondary
1
The dummy variable for diversied exporters equals one if the country is diversied in its export base and is equal to zero if
it is not. If no single category of exports accounts for 50% or more of total exports, the economy is classied as diversied. The
categories considered are non-fuel primary (SITC 0, 1, 2, 4, plus 68), fuels (SITC 3), manufactures (SITC 59, less 68), and services
(factor and non-factor service receipts plus workers remittances).
1012
Table 2
List of variables and expected coefcient signs.
Volatility
Volatility
Growth
Capital account openness
Capital account openness X nancial development
Initial GDP per capita/1000
Initial ination
Initial trade share of GDP
WV
Democracy index (01)
Black market premium in currency exchange
Revolutions per year
Gini coefcient of inequality
Rate of change of terms of trade
Standard deviation of rate of change of terms of trade
Log of total population
WG
Initial gross domestic investment (% of GDP)
Initial secondary education
Standard deviation of ination
Diversied exporters
Lagged nancial development
Dispersion of sectoral growth rates
Growth

or

or
or
or

or
or
or
or
or
or
or
or
or
or
or
or

or
school enrolment and the average long term growth of trade partners. Financial development is
instrumented by the average dispersion of growth rates among sectors and lagged nancial
development.
The measure of diversication is included only in the volatility equation (Eq. (1)) because while
diversication reduces volatility it does not necessarily have any direct impact on growth except
through the channel of volatility itself (Mobarak, 2005). Moreover, the measure of diversication does
not appear in the nancial development equation. Instead the more relevant measure the measure of
dispersion of growth rates across sectors is accounted for in that equation (Patrick, 1966).
The differentiated effect of capital account convertibility on volatility is measured by the interaction
between capital account openness and nancial development. This effect is derived from the boom
bust cycles of the theoretical literature (Aghion et al., 2000) where capital inows lead to excessive
volatility especially when nancial development is inadequate. This has obvious implications for
volatility, without there being any direct impact on average long-run growth except perhaps through
the channel of increased volatility itself (Ramey and Ramey, 1995).
The initial investment at the beginning of the decade, as a ratio of gross domestic product, and the
beginning of decade secondary school enrolment, are both used to instrument for growth. These are
both initial conditions2 and therefore are expected to have a direct impact on subsequent growth while
having only indirect inuence on volatility and nancial development via growth itself.
The average growth of trade partners appears in the growth equation to account for possible spillovers.
These have been found to be signicant determinants of growth (Moreno and Trehan, 1997; Easterly,
1996). These spillovers are excluded from other equations since the impact on nancial development can
reasonably expected to be at best indirect in nature, stemming from the channel of growth itself and the
trade partners impact on volatility is accounted for by including the average volatility of partners. The
average volatility of partners can, however, be reasonably expected to impact growth and is therefore
included in the growth equation as well and does not serve as an exclusion restriction.
2
For instance according to Barro and Lee (1994), the initial level of schooling should be interpreted exclusively as an initial
condition and not a proxy measure for human capital accumulation since in several cases it has actually been found to be
negatively correlated with growth in schooling.
1013
Lagged nancial development and dispersion of growth rates among sectors of the economy are
included only in the nancial development equation (Eq. (3)). While the former is a standard instrument for nancial development, the latter requires elucidation. Patrick (1966) analyzes both the
demand following and supply leading roles of nancial development in the economic growth process,
and concludes that rapid growth induces nancial development, as does greater dispersion among
growth rates of different sectors:
.with a given aggregate growth rate, the greater the variance in the growth rates among
different sectors or industries, the greater will be the need for nancial intermediation to
transfer savings to fast growing industries from slow-growing industries and from individuals.
The nancial system can thus support and sustain the leading sectors in the process of
growth.
This argument provides an innovative instrument for nancial development: sectoral dispersion of
growth rates. Sectoral dispersion of growth rates leads to a direct incentive for nancial intermediation
to transfer savings from lagging to leading sectors of the economy. Higher dispersion could indicate the
level of economic development and thus inuence growth rates. However, we take account of this by
including the level of initial gross domestic product per capita in the growth equation which is a proxy
for the stage of economic development. In addition, the direct relationship between dispersion of
growth rates across sectors and volatility is uncertain. While Lilien (1982) concludes that allocative
shocks lead to aggregate uctuations, Abraham and Lawrence (1986) present evidence to the contrary
indicating that aggregate shocks are the main driving force behind aggregate uctuations.
Tables 3 and 4 present the econometric tests for the exclusion restrictions discussed above. The rst
stage regressions in Table 3 show that the F-statistics for the joint signicance of the instruments is
relatively high with low P-values, providing support for the instruments used in the growth and the
nancial development equations. The instrument for volatility seems not to fare too well here.
However, the tests for over-identication presented in Table 4 lend support to the instruments used in
the volatility equation where we accept the null of valid instruments. The difference arises due to the
fact that volatility has an endogenous instrument in the form of the interaction term discussed above,
and this source of identication is ignored in the rst stage regressions which consider only exogenous
variables. In Table 4 the Hansen J-test of over-identication of all instruments leads us to accept the null
of valid instruments in the volatility and nancial development equations. In the growth equation we
reject the null. However, given the nature of the over-identication tests in the context of macroeconomic variables and our limited sample, this is not very surprising and need not be a signicant
setback (Murray, 2006).
5. Data
The data used in this work includes approximately 60 countries over 4 decades (19601999). The
data is annual and decade averages are used in the model estimation which condenses the data range
to four time periods. While performing the actual estimation this is further reduced to three time
periods due to the inclusion of the lag of nancial development in the model.
The IMFs yearly 01 indicator of capital account convertibility is used since this is the only measure
that is available for all countries over the entire sample period. Table 5 gives descriptive statistics on all
variables used in the model and Table 6 presents a comprehensive list of all the variables in the study
and their sources.
6. Estimation
To use the links between the endogenous variables in the system efciently, the model presented in
Section 5 (Eqs. (1)(3)) is estimated by a three-stage least squares methodology (3SLS).3 Given that we
3
In case the disturbances are un-correlated 3SLS simply boils down to 2SLS. Using OLS in this would tend to overestimate the
impact of endogenous variables by treating them as exogenous.
1014
Table 3
First stage regressionsa.

Initial ination
Diversied exporters
Constant
Observations
R-squared
F-stat. for joint signicance of instrumentsb
Prob. > F
(1)
(2)
(3)
Volatility
Growth
0.184 (0.41)
0.000 (0.22)
0.000 (0.81)
0.003 (0.37)
0.631 (0.98)
0.009 (0.06)
0.413 (0.80)
0.040 (2.12)*
0.059 (1.10)
0.037 (2.07)*
0.143 (0.86)
0.002 (1.37)
0.050 (1.94)
0.001 (0.12)
0.264 (0.96)
0.775 (5.02)**
0.001 (0.12)
1.963 (0.54)
178
0.52
0.91
0.34
0.996 (2.27)*
0.000 (0.61)
0.000 (0.75)
0.000 (0.02)
1.293 (2.05)*
0.332 (2.40)*
0.552 (1.09)
0.029 (1.56)
0.215 (4.10)**
0.003 (0.15)
0.199 (1.23)
0.001 (0.85)
0.059 (2.31)*
0.010 (1.18)
0.387 (1.43)
0.111 (0.73)
0.002 (0.20)
0.627 (0.18)
178
0.59
4.38
0.01
1.490 (0.41)
0.001 (2.03)*
0.004 (1.01)
0.030 (0.54)
4.568 (0.88)
0.555 (0.48)
4.814 (1.15)
0.420 (2.73)**
0.074 (0.17)
0.033 (0.23)
2.642 (1.97)
0.010 (0.96)
0.381 (1.82)
0.213 (3.20)**
2.887 (1.29)
1.580 (1.26)
0.827 (10.17)**
65.596 (2.24)*
178
0.87
54.43
0.00
Note: * signicant at 5%; ** signicant at 1%.

a
First stage regressions include the weighted averages of trade partners exogenous macro-variables which are not reported
in this table.
b
Instruments included in the F-test are diversied exporters for volatility, initial secondary school enrolment and initial
investment for growth, lagged nancial development and dispersion of sectoral growth rates for nancial development.
expect growth, volatility and nancial development to have links between them and be simultaneously
determined, the disturbances in the three equations can be reasonably expected to be correlated.
Under these circumstances, the 3SLS approach is consistent and in general asymptotically more efcient. The endogenous variables in the model are growth, its volatility, nancial development, the
interaction term of nancial development and capital account openness, and the spatial lags of growth
WtGt and volatility WtVt.4
The weighting matrix Wt is endogenous since one can reasonably expect a two-way relationship
between trade and growth. Due to this reason, unlike other works in the literature, Xt and WtXt5 cannot
be used as instruments for WtVt (the spatial lag of volatility) and WtGt (the spatial lag of growth).
Instead this work uses the instrumental variables approach suggested by Kelejian and Prucha (1998,
1999) to solve the problem of the endogenous weighting matrix. To do so, a predicted value of the
c t is rst obtained. Xt and W
c t Xt are used as instruments in the three-stage
weighting matrix, Wt, say W
least squares procedure. The problem of nding appropriate instruments for the trade shares in the
weighting matrix is solved by using a variant of the gravity model6 to instrument for trade shares in the
weighting matrix. A reduced form type model is developed where
4
The endogeneity of WtVt and WtGt can be proved using a simple example: starting with the following model,
1
thus
WY
is
endogenous
because,
Y Xb
i lWY 3; where jlj < 1,Y X b lWY 30Y I lWY X b 3,
EWY30 WI lW1 U3 s0.
2
5
EWY WX b W 2 Xlb W 3 Xl b . therefore in principle independent explanatory variables i.e. the Xs and higher
powers of the Xs, i.e. X2, X3, X4, X5, X6, ., Xq and WX, W2X, W3X, W4X, W5X, . WmX can potentially be used to instrument for the
endogenous variables of the model. In this estimation we set, q 1 and m 1.
6
In the gravity model, trade between countries is determined by the size of their respective economies and the distance
between them. In the empirical trade literature this has proved to be an exceptionally successful strategy for predicting trade
between countries.
1015
Table 4
Two stage least squares-tests of over-identication.
Volatility
WG
WV
Initial ination
Growth
Diversied exporters
Constant
Observations
Hansen J-test statistic (over-id test of instruments)
P-value
(1)
(2)
(3)
Volatility
Growth
0.048 (0.31)
0.003 (0.35)
0.753 (2.57)*
0.149 (0.75)
0.184 (0.52)
8.078 (1.99)*
0.030 (1.85)
0.242 (1.08)
2.237 (1.85)
0.000 (0.26)
0.001 (1.52)
0.004 (0.67)
1.382 (2.08)*
0.166 (1.11)
0.790 (1.58)
0.036 (1.77)
0.047 (0.31)
0.044 (0.95)
0.403 (2.12)*
0.003 (2.02)*
0.000 (1.25)
0.000 (0.99)
0.001 (0.12)
1.158 (2.10)*
0.287 (1.77)
0.558 (0.98)
0.024 (1.34)
0.203 (3.10)**
0.003 (0.12)
0.340 (2.47)*
0.001 (1.43)
0.074 (2.86)**
0.010 (1.14)
0.028 (0.18)
0.046 (1.81)
0.412 (1.58)
8.058 (2.19)*
178
22.124
0.18
0.001 (2.37)*
0.000 (0.15)
0.019 (0.28)
4.191 (0.83)
0.237 (0.17)
0.361 (0.08)
0.398 (2.25)*
1.227 (2.04)*
0.102 (0.70)
0.771 (0.47)
0.005 (0.73)
6.078 (2.64)**
3.711 (1.28)
178
32.805
0.01
0.923 (11.57)**
0.630 (0.47)
42.904 (1.76)
183
2.027
0.15
Robust z statistics in parentheses.

Note: * signicant at 5%; ** signicant at 1%.
wij;t a bwij;t1 gPi;t dPj;t 2Dij fYi;t1 qYj;t1 hij;t ;
(4)
for all wij;t > 0. wij;t is the ijth nonzero element of Wt. It is therefore, the trade share of country j in
the total trade of country i when country j is a signicantly major trade partner of country i; Pn;t is
the population of country n in period t, normalized by the world population in period t. The
normalization is important since the dependent variable is trade share and therefore by denition
less than 1. Dij is the distance in kilometers between i and j, normalized by the longest distance in
the sample; Yn;t1 is the lagged gross domestic product of country n, normalized by the total
world gross domestic product; and hij;t is the disturbance term. Given the exogenous nature of
distance, it ensures identication of the instrumented trade shares. The model represented by Eq.
b ij;t is obtained, which
(4) is estimated by an Ordinary Least Squares method and the tted value w
c t Xt are then used as instruments in the subsequent 3SLS
c t . Xt and W
results in the estimated W
procedure.
c t Xt serve as instruments for the
The analysis presented in this section shows that Xt and W
7
c
endogenous variables. W t is estimated using an instrumental variables approach, with
a variant of the trade gravity model providing the instruments for the endogenous matrix of
trade shares Wt. The results obtained after estimating Eqs. (1)(3) using 3SLS are discussed in
Section 7.
7 c
W t converges asymptotically to the mean of Wt and depends only on predetermined variables. It is not used to replace the
Wt in the regression itself; it only appears in the instruments.
1016
Table 5
Descriptive statistics.
Variable
Mean
Std. dev.
Min
Max
Volatility (standard deviation of growth)

Volatility (inter-quartile range of growth)
Growth
Capital account openness X Financial development
Financial development (Credit to private sector/GDP)
Financial development (BANK)a
Financial development (LLY)b
Financial development (PRIVATE)c
Initial GDP per capita
Initial ination
WV
WG
Diversied exporters
4.32
6.97
2.23
0.24
11.35
34.10
74.38
39.04
77.99
5126.94
47.25
68.45
2.67
0.57
2.47
0.16
41.51
.28
8.05
15.50
2.79
22.57
43.13
54.35
0.31
3.34
3.29
5.64
3.08
0.38
26.67
28.89
22.59
26.29
48.42
7991.10
422.81
48.38
1.02
0.33
1.34
0.28
9.94
3.27
11.32
1.96
1.27
9.29
31.26
469.84
0.46
1.32
0.17
0
10.78
0
0
1.13
10.69
2.49e06
5.48
89.35
12.05
3.68
0
0
0.46
0
19.9
11.66
0
10.62
0
1.76
1
0
0
0.14
31.73
63.7
19.38
1
168.04
186.71
287.2973
191.24
771.59
45,965.61
6836.98
439.03
7.41
1
8.76
2
65.38
25.29
93.27
20.90
7.62
82.25
130.18
8633.69
1
9.64
a
The ratio of deposit money bank domestic assets to the sum of deposit money bank domestic assets and central bank
domestic assets labeled BANK in the King and Levine (1993) analysis.
b
The ratio of M2 to GDP is labeled LLY in the King and Levine (1993) analysis.
c
The ratio of non-nancial private sector claims to total domestic credit is labeled PRIVATE in the King and Levine (1993)
analysis.
7. Results
Table 7 presents results from estimating Eqs. (1)(3). Column entitled volatility, growth and
nancial development, present the regression coefcients obtained from 3SLS estimation of Eqs. (1)
(3). Column 1 shows that capital account liberalization increases volatility signicantly, while the
interaction between nancial development and capital account liberalization reduces it. The magnitude of the coefcients indicates that the volatility increasing impact of capital account liberalization is
completely dampened in countries with a ratio of private credit to gross domestic product of roughly
49% or above. In other words, the results show that if a country is sufciently nancially developed it
can avoid excess volatility that results from having an open capital account. The average private credit
to gross domestic product ratio in the sample of countries in this study is approximately 29%, 38% and
44% in the decades of the 1970s, 1980s and 1990s, respectively. Countries that have an average private
credit to gross domestic product ratio below 49% during the 1970s, but move above it by the 1990s,
include Australia, Belgium, Chile, Finland, Ireland, Israel, Jordan, South Korea, Malaysia, New Zealand,
Saudi Arabia, Thailand and the United Kingdom.
Column 3 (Table 7) shows that the nancial development regression yields evidence of capital
convertibility having a positive signicant impact on nancial development which is in line with the
argument that openness itself leads to further development of nancial structures through increased
competition, innovation and discipline brought on by international market exposure (Kaminsky and
Schmukler, 2003). In column 2 (Table 7), the growth regression reveals that the direct impact of capital
convertibility on growth is insignicant. This is not surprising given the contradictory results of past
work and theory that links capital account openness directly to volatility of growth rather than growth
itself.
1017
Table 6
Data sources.
Variable
Source
Volatility (standard deviation of growth rate of gross domestic

product per capita)
Growth (growth rate of gross domestic product per capita)
Financial development (ratio of private sector credit to gross
domestic product)
Financial development (the three other measure used in the
robustness tests)
Ination
World Development Indicators, World Bank
Trade weights to calculate the spillover matrix

Dummy for diversied exporters
Direction of trade statistics, International Monetary Fund

IMF annual reports on exchange restrictions
International Financial Statistics, International Monetary
Fund
World Development Indicators, World Bank and Global
Development Finance
Direction of Trade Statistics, International Monetary Fund
Freedom House website www.freedomhouse.org/ratings
Global development network growth database
Arthur S. Banks Cross National Time-Series Data Archive
Lundberg and Squire (2003)
Mobarak (2005)
World Development Indicators, World Bank and Global
Development Finance
Global Development Network Growth Database
World Development Indicators, World Bank and OECD/
website
In columns 1 and 2 (Table 7) the coefcients on the spillover effects are positive and signicant in
the growth equation and insignicant in the volatility equation. The insignicance of volatility spillovers in the long-run might be attributable to the fact that volatility spillovers tend to smooth out
overtime and so they really are an insignicant consideration in the long-run or it could be that trade
shares do not propagate volatility spillovers to the extent that perhaps channels of international
nance (Kaminsky and Reinhart, 2000).
The empirical model results show that volatility increases with a high credit to gross domestic
product ratio and a high standard deviation of terms of trade change (column 1, Table 7). The latter
nding is in accordance with the Mendoza (1995) model, where terms of trade shocks contribute
substantially to gross domestic product variability. In the same equation, a more democratic society
and higher population dampen volatility. There are a number of reasons for democracy to reduce
volatility as discussed by Mobarak (2005). In addition, population is a measure of diversication and
expectedly has a negative impact on volatility. All other coefcients in the volatility regression have the
expected signs except nancial development, which has a positive signicant coefcient. The
contradiction is resolved when we consider the total impact of nancial development which consists of
the coefcient on nancial development together with the coefcient on its interaction with capital
account openness. The total impact of nancial development is to lessen volatility in nancially
developed countries with relatively open capital accounts; this is in line with our expectations.
In column 2 (Table 7) the growth equation yields a negative coefcient of initial gross domestic
product per capita, this is consistent with the convergence prediction of neoclassical growth models,
which is based on the assumption of diminishing returns to reproducible capital and implies that poor
countries tend to grow faster than rich ones. Moreover the coefcients on democracy and the black
market premium in currency exchange (which is a composite measure of government policy) are both
negative and signicant. A higher black market premium is a proxy for greater intervention in the
economy, especially the currency market by the government and could hinder growth. The result that
the rate of change of terms of trade has a signicant positive coefcient is in accordance with Mendoza
(1996) who predicts the inuence of terms of trade variability on growth. The log of population and the
initial ratio of investment to gross domestic product have a signicant positive impact on growth as
well.
1018
Table 7
Results obtained from 3SLS estimation of Eqs. (1)(3) of the empirical model.
Volatility
Volatility
Growth
WG
WV
Initial ination
Diversied exporters
Constant
Observations
Growth
0.056 (0.40)
0.008
0.035
2.445
0.050
(0.05)
(2.61)***
(1.98)**
(2.18)**
0.278 (1.19)
0.000 (0.18)
0.001 (1.64)*
0.004 (0.62)
1.362 (2.20)**
0.177 (1.11)
0.843 (1.52)
0.035 (1.68)*
0.049 (0.75)
0.045 (2.45)**
0.413 (2.45)**
0.002 (1.78)*
3.998 (3.93)***
0.005 (0.61)
0.187 (0.50)
0.769 (2.59)***
0.206 (0.85)
0.000 (1.82)*
0.000 (0.52)
0.000 (0.04)
1.183 (1.98)**
0.272 (2.11)**
0.549 (1.11)
0.024 (1.38)
0.203 (3.93)***
0.001 (0.04)
0.306 (2.08)**
0.001 (0.84)
0.075 (2.94)***
0.012 (1.59)
6.611 (2.14)**
0.001
0.000
0.054
3.236
0.211
0.007
0.385
0.486
0.142
2.209
0.002
(3.03)***
(0.13)
(1.15)
(0.73)
(0.19)
(0.00)
(2.79)***
(1.03)
(1.07)
(1.87)*
(0.22)
0.050 (2.18)**
0.475 (1.56)
8.285 (2.57)**
178
3.219 (1.06)
178
0.904 (13.87)***
2.503 (2.25)**
64.507 (2.83)***
178
Absolute value of z statistics in parentheses.

* Signicant at 10%; ** signicant at 5%; *** signicant at 1%.
In column 3 (Table 7), nancial development varies positively with its lag. This is not surprising
since we would expect the ratio of private credit to gross domestic product to exhibit persistence on
average. At the same time, higher dispersion of sectoral growth rates has a signicant positive impact.
The latter is an instrument of nancial development proposed in this paper and yields the expected
result: greater dispersion among growth rates of sectors leads to higher levels of nancial development. Initial gross domestic product per capita, capital account openness, economic growth and an
equitable distribution of income all have positive signicant coefcients. The results are in accordance
with theoretical models of nancial development (Patrick, 1966; Greenwood and Jovanovic, 1990;
Greenwood and Smith, 1997).
To summarize, Table 7 represents the results of the 3SLS regression. The data supports the
hypothesis that the impact of capital account openness depends upon the level of nancial development in a way that developed countries suffer lesser volatility as a result of the liberalization policy. In
addition, capital account openness itself leads to higher nancial development.
8. Sensitivity tests
Sensitivity tests are carried out to assess the robustness of the empirical results in this study. Table 8
presents the results of a battery of sensitivity tests: we test for robustness to alternate measures of
nancial development, volatility and to outliers. All tests suggest our results are quite robust: in all
cases but one, our results are signicant. The case where the results turn out to be insignicant is under
one of the alternate measures of nancial development; even then, the sign of the coefcients is still
validated.
The rst three columns present results when alternate measures of nancial development are used
from the King and Levine (1993) study. The measure used in the main results the ratio of credit issued
to private rms to gross domestic product is one of the measures used in the King and Levine (1993)
Different nancial development measures
Growth
Capital account openness X
nancial development
Diversied exporters
Observations
Removing outliers
Volatility
Volatility
Volatility
Volatility
Volatility
Inter-quartile range
Financial Development
Measure 1a
Measure 2b
Measure 3c
Less top 10%

richest countries
Less bottom 10%

poorest countries
Different measure
of volatility
0.20 (1.28)
12.84 (2.69)***
0.17 (2.77)***
0.23 (1.38)
4.96 (2.44)**
0.13 (2.93)***
0.05 (0.34)
4.51 (1.15)
0.06 (1.27)
0.11 (0.62)
4.38 (1.89)*
0.12 (2.14)**
0.14 (0.75)
3.02 (2.51)**
0.06 (2.76)***
0.11 (0.41)
3.81 (1.88)*
0.08 (2.12)**
0.04 (1.81)*
0.72 (2.12)**
167
0.05 (2.79)***
0.71 (1.78)*
136
0.02 (1.52)
0.49 (1.70)*
170
0.04 (2.15)**
0.52 (1.33)
147
0.05 (3.44)***
0.43 (1.30)
164
0.06 (2.68)***
0.61 (1.21)
178
Absolute value of z statistics in parentheses.

* Signicant at 10%; ** signicant at 5%; *** signicant at 1%.
a
Financial Development Measure 1 is the ratio of deposit money bank domestic assets to the sum of deposit money bank domestic assets and central bank domestic assets. This is the
measure of nancial development labeled BANK, in the King and Levine (1993) analysis.
b
Financial Development Measure 2 is the ratio of M2 to GDP. This is the measure of nancial development labeled LLY, in the King and Levine (1993) analysis.
c
Financial Development Measure 3 is the ratio of non-nancial private sector claims to total domestic credit. This is the measure of nancial development labeled PRIVATE, in the King
and Levine (1993) analysis.
Table 8
Robustness tests based on alternate measures of nancial development, removal of outliers.
1019
1020
study. The remaining three measures from the King and Levine study are used in the robustness checks
represented by columns 1, 2, and 3 in Table 8. In column 1, the ratio of liquid liabilities to Gross
Domestic Product is used to measure nancial development. This is a traditional measure of nancial
depth. Column 2 presents results when the importance of banks relative to the central bank in allocating domestic credit, i.e., the ratio of deposit money bank domestic assets to deposit money bank
domestic assets plus central bank domestic assets is used to measure nancial development. This
measure helps to indicate the relative importance of specic nancial institutions. Column 3 presents
results when the percentage of credit allocated to private rms, i.e., the ratio of claims on the nonnancial private sector to total domestic credit, is used to measure nancial development. This indicator is designed to measure domestic asset distribution. The differential impact of capital account
openness based on nancial development carry through in all cases, but the coefcients in column 3
are not signicant. Thus the results are insignicant only when the nancial development measure is
based on the percentage of credit allocated to the private sector. A probable explanation is that this
measure is actually a measure of the overall size of the public sector rather than being an accurate
indicator of the level of nancial development.
Columns 4 and 5 present results with the richest and poorest countries removed from the sample.
Column 4 (Table 8) represents results where the top 10% of countries in terms of per capita gross
domestic product are removed. The differential effect of capital account liberalization carries through
in this case, though the coefcient of capital account liberalization itself is only marginally signicant.
Column 5 represents results when the bottom 10% of countries, in terms of per capita gross domestic
product, is removed from the sample. The sensitivity tests show that the results are robust in this case
as well. Column 6 in Table 8 presents the results of using the inter-quartile range to measure volatility8
instead of the standard deviation. The results are robust to this measure.
9. Conclusion
This paper primarily investigates the impact of capital account openness on the volatility of growth.
The role of nancial development in determining this impact is the major focus of this study. The
empirical model is based on three simultaneous equations representing economic growth, nancial
development and volatility. The paper attempts to address the issues of causality and endogeneity that
arise in the context of the investigation by allowing for links between growth, nancial development
and volatility and for capital account openness to have feedback effect into nancial development
itself. The empirical results verify the implications of theory that capital account openness leads to
excess volatility unless the economy is sufciently nancially developed. At the same time, capital
account openness itself contributes positively to nancial development. These ndings highlight the
importance of careful handling of the capital account liberalization process by policy makers.
A balanced approach will entail both the consideration of an economys readiness for liberalization as
well as the potential costs and benets based on its level of nancial development.
Acknowledgements
The author would like to thank the University of San Francisco, for providing a generous fellowship
for support of this research. The author would also like to thank the International Monetary Fund (IMF)
for facilitating access to some of the data sources used in this study.
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Journal of International Money and Finance 28 (2009) 10061021

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Journal of International Money

Ready for capital account convertibility?

This paper investigates whether the impact of capital account

* Tel.: 1 (202) 294 2037; fax: 1 415 422 6983.

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Period without restriction

19811982, 19951996, 19981999

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Fi;t g0 gt g1 Fi;t1 g2 Ki;t g3 Gi;t X3i;t g4 33i;t ;

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Capital account openness

Note: * signicant at 5%; ** signicant at 1%.

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Robust z statistics in parentheses.

wij;t a bwij;t1 gPi;t dPj;t 2Dij fYi;t1 qYj;t1 hij;t ;

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Volatility (standard deviation of growth)

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Volatility (standard deviation of growth rate of gross domestic

World Development Indicators, World Bank

Trade weights to calculate the spillover matrix

Direction of trade statistics, International Monetary Fund

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

Absolute value of z statistics in parentheses.

Different nancial development measures

Less top 10%

Less bottom 10%

Absolute value of z statistics in parentheses.

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

P. Mukerji / Journal of International Money and Finance 28 (2009) 10061021

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