Endogenous Financial and Trade Openness

Working Paper: NBER ID: w10496

Authors: Joshua Aizenman; Ilan Noy

Abstract: This paper studies the endogenous determination of financial and trade openness. First, we outline a theoretical framework leading to two-way feedbacks between the different modes of openness; next, we identify these feedbacks empirically. We find that one standard deviation increase in commercial openness is associated with a 9.5 percent increase in de-facto financial openness (% of GDP), controlling for political economy and macroeconomic factors. Similarly, increase in de-facto financial openness has powerful effects on future trade openness. De-jure restrictions on capital mobility have only a weak impact on de-facto financial openness, while de-jure restrictions on the current account have large adverse effect on commercial openness. Having established (Granger) causality, we investigate the relative magnitudes of these directions of causality using Geweke's (1982) decomposition methodology. We find that almost all of the linear feedback between trade and financial openness can be accounted for by G-causality from financial openness to trade openness (53%) and from trade to financial openness (34%). We conclude that in an era of rapidly growing trade integration countries cannot choose financial openness independently of their degree of openness to trade. Dealing with greater exposure to financial turbulence by imposing restrictions on financial flows will likely be ineffectual.

Keywords: No keywords provided

JEL Codes: F15; F21

Causal Claims

Cause	Effect
Defacto Financial Openness (F30)	Trade Openness (F43)
Commercial Openness (L17)	Trade Openness (F43)
Dejure Restrictions on Capital Mobility (F21)	Defacto Financial Openness (F30)
Restrictions on Current Account (F32)	Commercial Openness (L17)
Commercial Openness (L17)	Defacto Financial Openness (F30)
Defacto Financial Openness (F30)	Commercial Openness (L17)