Pakistan Journal of Social Sciences (PJSS)

Vol. 39, No. 3, (2019), pp. 817-826

Capital Account Liberalization and Domestic Investment:

A Panel Data Analysis for Emerging Market Economies
Muhammad Atiq Ur Rehman
PhD Scholar, Department of Economics,
University of the Punjab, Lahore, Pakistan
Email: [email protected]

Hafeez Ur Rehman
Professor and Chairman, Department of Economics,
University of Management and Technology, Lahore -Pakistan
Email: [email protected]

Furrukh Bashir (Corresponding Author)

Assistant Professor, School of Economics,
Bahauddin Zakariya University, Multan -Pakistan
Email: [email protected]

Abstract:
The effects of financial globalization on emerging market economies
(EMEs) have been a matter of concern for the policymakers. This study
is an attempt to explore the impact of capital account liberalization on
domestic investment in 17 major EMEs for the period 1991-2015.
Generalized method of moments (GMM) and fixed effects (FE)
techniques are employed by using different de facto and de jure
measures of capital account liberalization. The empirical results
indicate that financial liberalization affects domestic investment
positively and significantly only when foreign direct investment (FDI)
measure is considered. All the other de facto and de jure measures
remain statistically insignificant. FDI facilitates the import of
sophisticated production techniques and encourages the propagation of
a competitive environment in the EMEs which in turn stimulates
domestic investment.

Keywords: Capital Account Liberalization, Foreign Direct Investment, Emerging

Market Economies

I. Introduction
The global economic architecture has changed dramatically due to substantial
financial flows across countries since the 1980s. According to the economic theory, the
allocative efficiency of investment is increased through capital account liberalization.
The liberalized capital flows across nations alleviate credit constraints by channeling
finances from rich to poor economies. The easy availability of finances leads to the
optimal utilization of resources and encourages growth and investment. Theoretical
literature explains the various mechanisms through which capital account openness
affects macroeconomic performance. The improved banking sector efficiency and
financial market development triggered by financial openness also help agents about the
international diversification and better utilization of finances. The main objective of
minimizing capital controls by the developing countries was to encourage the influx of
monetary resources from abroad.
818 Pakistan Journal of Social Sciences Vol. 39, No. 3

McKinnon and Shaw (1973) propose the elimination of regulatory controls on

capital movements for the better performance of an economy. They pointed out that the
liberalized capital flows and efficient financial system can divert finances from low yield
projects to highly profitable investments. The government role in the financial system
should be minimized and the financial institutions should be able to perform their
functions independently. The liberalization of capital markets induces the financial
mediators to provide finances for more prolific investments. Financial liberalization
encourages equity investment and gives vent to the vibrant stock markets. The proficient
stock markets also increase investment efficiency by allocating finances to highly
profitable ventures. Financial liberalization helps capital movements towards capital-
scarce destinations by augmenting domestic savings and stimulating domestic
investment. The emerging market economies have been greatly relying on FDI since the
1980s. Capital inflows in the form of FDI proved to be an engine of economic
development for the East Asian economies.

Financial liberalization can stimulate investment by raising the saving rate or

facilitating appropriate allocation of financial resources. Moreover, the financial sector
deepening can fill the saving-investment gap of a capital-scarce economy. The easy
availability of international credit also contributes to allocate credit for profitable
investments. Hence, capital flow liberalization is expected to make investment more
profitable by pooling financial resources. The liberalized capital markets along with a
properly functioning financial system can perform a pivotal role in encouraging better
capital utilization and facilitating profitable investments. The past experiences show that
emerging market economies have great potential for productive investments; however,
some kind of capital inflows may lead to external imbalances and macroeconomic
volatility.

II. Literature Review

While assessing the relationship between capital account liberalization and
domestic investment, literature has been paying considerable attention to the interest rate
deregulation and the abolition of financial repression. Galbis (1977) examines the role of
financial deregulation in enhancing the allocative efficiency of investment and raising
returns. Fry (1989) and Gibson and Tsakalotos (1994) find a positive role of financial
liberalization by using endogenous growth models. They explain that the efficient
mobilization and optimal utilization of financial resources promote profitable investment
ventures.

Atje and Jovanovic (1993) discover a supportive role of stock market

capitalization to enhance the economic activity in 40 economies for the period 1980-88.
The authors explain that the developed financial sector informs agents about lucrative
investment opportunities and raise profit margins. Bayoumi (1993) studies the effect of
capital account openness on savings and investment in the UK. He concludes that the
financial market deregulations make savings and investment more dependent on the
interest rates.

Pagano (1993) explores that the liberalization of financial markets encourages

investment by properly channeling savings to profitable investment ventures. Berthelemy
and Varoudakis (1996) conclude that the financial liberalization develops domestic
financial sector which accumulates savings and increases investment. Levine and Zervos
 Muhammad Atiq Ur Rehman, Hafeez Ur Rehman, Furrukh Bashir 819
(1998) develop an extended version of Atje and Jovanovic (1993) model. By controlling
for different political and economic features and using augmented sample size, the
authors find a positive association between stock market liquidity and investment.

Jaramillo, Schiantarelli and Weiss (1996) explore that financial liberalization

does not influence financing constraints and investment in the case of Ecuador. Henry
(2000) empirically examines the effect of liberalized stock markets on private investment
in 11 emerging economies. It is found that the stock market liberalization temporarily
raises private investment in most of these economies. Laeven (2000) uses the data of 13
developing countries to examine the role of financial openness in reducing financial
constraints. It is found that the liberalized capital flows reduce financing constraints of
small firms. However, the outcome of financial deregulation on investment is influenced
by macroeconomic stability and institutional efficiency of an economy.

Razin (2002) explores that FDI plays a more significant role in promoting
domestic investment as compared to other portfolio capital flows. Hermes and Lensink
(2006) investigate the influence of liberalized capital flows in the case of 25 transition
economies. The authors fail to obtain substantial empirical support in favor of the
positive nexus between financial openness and domestic investment. Pagano and Jappelli
(2006) point out that the liberalization of financial flows can relax credit constraints and
lower the rate of household savings. A reduction in savings may result in lower
investment. Mileva (2008) empirically examines that one dollar of FDI inflows produces
nearly one additional dollar of domestic investment in emerging market economies. Luca
and Spatafora (2012) empirically examine the linkages between financial liberalization,
capital market deepening and investment in the developing countries. The results indicate
a positive impact of liberalized financial flows and domestic credit on domestic
investment. The study also suggests that the better quality of institutions and coherent
macroeconomic policy are the imperative factors in finance-investment nexus.

Ayouni et al. (2014) examine the relationship between FDI inflows and
domestic investment in 69 developed and developing countries for the period 1985-2008.
The empirical results show that the FDI inflows increase exports competitiveness of the
host economy. The increase in exports encourages domestic investment. FDI has
favorable effects in only those economies where the financial sector is properly
developed.

Ivanović (2015) investigates the impact of net inflow of foreign capital on

domestic investment in the Republic of Croatia using quarterly data for the period 2001-
2014. The results show that FDI negatively influences domestic investment in Croatia
with a time lag. Zuzana (2015) studies
study the effect of FDI on domestic investment in the
economies of central and Eastern Europe including the Czech Republic, Estonia,
Hungary and Slovakia. It is empirically found that the foreign companies crowd out
domestic investment in the host economies.

III. Data and Empirical Methodology

Emerging economies are those destinations which have greater expected returns
with a higher risk of macroeconomic volatility. The study uses IMF (2015) classification
for the selection of seventeen main Emerging market Economies including Argentina,
Brazil, Chile, China, Hungry, India, Indonesia, Malaysia, Mexico, Pakistan, Philippines,
820 Pakistan Journal of Social Sciences Vol. 39, No. 3

Poland, Russia, Thailand, Turkey, Ukraine, and Venezuela for the period 1991-2015.
Mody and Murshid (2005) developed a generalized model to estimate the effect of capital
account liberalization on domestic investment which can be written in the following form

Iit = αIit-1+ βZit+ γ FLit + μit (1)

In equation (1) i = 1, 2, 3..., 17 refers to the 17 emerging economies and t =

1991…2015 represents the time period. Where Iit is gross capital formation as a
percentage of GDP representing domestic investment, FLit indicates financial
liberalization and u is the error term.

Zit is a vector of control variables containing real GDP growth (GDP), Money
supply (M2), Government expenditure (GE), inflation (INF), and trade openness (TO).
Hence, the above-given equation can be written as

Iit = αIit-1+ β1GDPit + β2M2it + β3GEit+β4INFit + β5 TOit+ γ FLit + μit (2)

The data on control variables and investment are obtained from the WDI.
Different de facto and de jure measures are used to represent capital account
liberalization. De facto measures symbolize the capital flows actually occurred. These
measures are considered to be a better representation of capital account openness due to
their less volatile nature. Total liabilities, total Assets plus liabilities and FDI are the de
facto measures used in this study. The data on total assets and assets plus liabilities as
shares in GDP are obtained from the External Wealth of Nations dataset1. FDI data are
obtained from WDI database. De jure measures embody the legal restrictions on financial
flows across borders. Chin-Ito capital account openness (KAOPEN) index and Schindler
index are the de jure measures incorporated in our empirical analysis. Chin-Ito index is
characterized by the codified restrictions on monetary flows. The number 0 represents
fully regulated while 1 implies fully open economy. Schindler's index is also presented in
the coded form with 0 for fully open and 1 for a fully closed economy. The GMM system
technique has the advantage of controlling the potential endogeneity bias. Fixed effect
estimation technique is also adopted for assessing the robustness.

IV. Empirical Results

Table 1 shows the effect of de facto capital account liberalization on domestic
investment. Total liabilities, total liabilities plus assets, and FDI as a percentage of GDP
are the de facto measures considered for the empirical analysis. The empirical results
show that only FDI affects domestic investment positively and significantly. The GMM
results point out that a one percentage point increase in FDI inflows causes domestic
investment to increase by nearly 6 percentage points or vice a versa. The positive effect
of FDI is also confirmed by the fixed effects. FDI promotes domestic investment by
importing modern production techniques 2and improved managerial skills. An inflow of
foreign currency helps to strengthen the domestic currency and makes investment goods
cheaper. So, the total savings increase which stimulates investment. FDI imports
sophisticated production techniques, reduces the cost of production and accumulates
domestic capital. The capital accumulation in an economy crowds in domestic

1
See Lane and Milesi-Ferretti (2007)
2
See Bosworth et al. (1999)
 Muhammad Atiq Ur Rehman, Hafeez Ur Rehman, Furrukh Bashir 821
investment (Ndikumana & Verick, 2008). The economic incentives and a better business
environment to attract FDI will also incentivize domestic investors.
The empirical results of our study are in line with Razin (2002), Schularick
(2006), and Gehringer (2012). The GMM and FE methods indicate that a one percentage
point upsurge in the supply of money is associated with a rise in domestic investment by
9 to 12 percentage points. In addition, GDP and M2 appear with statistically significant
coefficients in GMM regressions but this significance is not consistent in case of fixed
effects. The total liabilities affect investment negatively which indicates a debt overhang
situation. The other variables including government expenditure, inflation, trade openness
and assets plus liabilities are all found to be insignificant. The coefficients on lagged
investment are found to be strongly significant because the returns on previous year
investment help to accumulate savings and stimulate future investments. The p-values
pertaining to Hansen test are reported from the second step of GMM for the consistency
purposes3. Hansen statistics reflected from p-values points out towards the correct
specification of instruments. The absence of second-order serial correlation is reflected
from the insignificant p-values of Arellano-Bond test.
Table 1: Effect of De Facto Capital Account Liberalization on Domestic Investment
Dependent
Logarithmic Growth Rate of Domestic Investment (I)
Variable
Method System GMM Fixed Effects
Equation (1) (2) (3) (1) (2) (3)
0.5808* 0.6509* 0.6744* 0.5437* 0.6563* 0.6824*
I (-1)
(0.1055) (0.1158) (0.1084) (0.1217) (0.1263) (0.1133)
0.0276* 0.0198** 0.0213* 0.0171** 0.0113 0.0111
GDP
(0.0082) (0.0085) (0.0072) (0.0075) (0.0079) (0.0078)
0.1212** 0.1184** 0.1157** 0.0766 0.0769 0.0729***
M2
(0.0559) (0.0544) (0.0462) (0.0515) (0.0521) (0.0428)
0.1604** 0.1090 0.0232 0.0602 0.0408 -0.0807
GE
(0.0617) (0.0729) (0.0718) (0.0778) (0.0829) (0.0845)
0.0023 0.0019 0.0036*** 0.0004 0.0006 0.0022
INF
(0.0022) (0.0217) (0.0019) (0.0016) (0.0016) (0.0018)
0.0534 -0.0153 -0.0546 0.0698 0.0006 -0.0677**
TO
(0.0539) (0.0511) (0.0388) (0.0433) (0.0451) (0.0319)
Total -0.1525* -0.1996*
Liabilities (0.0687) (0.0492)
Total
-0.0439 0.0909
Liabilities +
(0.0678) (0.0573)
Assets
0.0616*** 0.0692***
FDI
(0.0329) (0.0364)
1.0149** 0.7502 0.7441
Constant
(0.4502) (0.4815) (0.4214)
R-Squared 0.70 0.66 0.68
Groups 17 17 17
Observations 68 68 68 68 68 68
Hansen
0.663 0.773 0.803
(p-value)
AB m2
0.798 0.997 0.823
(p-value)
Note:One-step robust system GMM and FE methods are used for the estimation of panel data with five-year non-overlapping averages. Robust
standard errors are reported in parentheses; *, ** and *** indicate significance at 1, 5 and 10 percent level respectively. Hansen test p-values are
obtained by estimating the second step of GMM.

3
Second step of GMM gives consistent Hansen statistics (Roodman, 2009).
822 Pakistan Journal of Social Sciences Vol. 39, No. 3

Table 2 exhibits the impact of de jure capital account liberalization on domestic

investment. The empirical results show that both de jure measures consisting of Chin-Ito
and Schindler indices stand statistically insignificant in all regressions. De jure measures
have a tendency to remain statistically insignificant because of their limited ability to
mirror the actual intensity of capital account liberalization. Government spending,
inflation and trade openness are the control variables appearing with statistically
insignificant coefficients. The lag dependent variable is statistically significant in all
regressions. The coefficients on M2 and GDP are positive but not consistently significant.
The Hansen p-values indicate correct specification of instruments. Arellano-Bond test
indicates the absence of second-order serial correlation.

Table 2: Effect of De Jure Capital Account Liberalization on Domestic Investment

Dependent
Logarithmic growth rate of domestic investment (I)
Variable
Method System GMM Fixed Effects
Regression (4) (5) (4) (5)
0.6418* 0.6335* 0.6700* 0.6608*
I (-1)
(0.1142) (0.1167) (0.1227) (0.1226)
0.0197** 0.0185** 0.0114 0.0105
GDP
(0.0084) (0.0068) (0.0096) (0.0085)
0.1093** 0.1114*** 0.0747 0.0742
M2
(0.0515) (0.0532) (0.0503) (0.0515)

0.0822 0.0903 0.0167 0.0231

GE
(0.0565) (0.0596) (0.0814) (0.0856)
INF 0.0016 0.0020 0.0004 0.0008
(0.0024) (0.0021) (0.0018) (0.0017)
-0.0319 -0.0358 -0.0442 -0.0465
TO
(0.0383) (0.0386) (0.0344) (0.0329)
-0.0129 -0.0098
KAOPEN Index
(0.0226) (0.0212)
Schindler(2009), 0.0726 0.0710
KA index (0.0919) (0.0866)
Constant 0.5019 0.5235
(0.4798) (0.4784)
R-Squared 0.65 0.65
Groups 17 17
Observations 68 68 68 68
Hansen (p-value) 0.694 0.794
AB m2 (p-value) 0.844 0.849
Note:One-step robust system GMM and FE methods are used for the estimation of panel data with five-year non-overlapping
averages. Robust standard errors are reported in parentheses; *, ** and *** indicate significance at 1, 5 and 10 percent level
respectively. Hansen test p-values are obtained by estimating the second step of GMM.

V. Conclusion and Policy

The study examines the impact of capital account liberalization on domestic
investment in the selected major emerging market economies. The GMM and fixed-
effects techniques of panel data estimation are employed by incorporating some common
de facto and de jure financial liberalization measures. The empirical estimates indicate
that only FDI influences domestic investment positively and significantly. The total
liabilities affect Domestic investment negatively while other measures remain statistically
insignificant. It is concluded that FDI is the most beneficial capital inflow for The EMEs.
 Muhammad Atiq Ur Rehman, Hafeez Ur Rehman, Furrukh Bashir 823
It imports sophisticated production techniques and causes domestic capital accumulation
which crowds in domestic investment. A rational macroeconomic policy should be
designed to liberalize capital flows. The short-term portfolio inflows should be avoided
because they are more volatile and have a tendency to bring macroeconomic fluctuations.
The focus of the policy should be on attracting long-term and stable capital flows. Special
attention should be paid to attract FDI flows due to their least volatile nature and
advantageous outcomes. Foreign investors can be enticed by providing an investment-
friendly environment with better infrastructure and lucrative incentives in the emerging
market economies.

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