EFFECTIVENESS OF LEGAL CONTROLS IN LIMITING FINANCIAL DERIVATIVES’ FLOWS: EVIDENCES FROM PANEL DATA
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EFFECTIVENESS OF LEGAL CONTROLS IN LIMITING FINANCIAL DERIVATIVES’ FLOWS: EVIDENCES FROM PANEL DATA
MODULE CODE: SEESGS51
STUDENT NUMBER: 14094050
WORD COUNT: 2966
SCHOOL OF SLAVONIC & EAST EUROPEAN STUDIES
INTERNATIONAL MASTERS IN ECONOMY, STATE AND SOCIETY (ECONOMICS AND BUSINESS)
27TH APRIL 2015
INTRODUCTION Financial account liberalization has been advocated as a significant determinant of economic development by both academics as financial institutions. Flows of foreign capitals stimulate economies and boost domestic financial markets, from which local firms get access to more, cheaper capitals. However, the Great Recession of 2008 sparked new doubts and debates; while it is unequivocal that free flows of capitals can enhance development, the Global Financial Crisis witnessed their magnitude in destabilizing economies and spreading systemic risk to others. The IMF was one of the first organizations to change its position, suggesting that controls on flows of capitals may be a valid tool of macroeconomic and macroprudential management when other tools have been exhausted (IMF, 2011a). Academic research has more accurately investigated different aspects of this phenomenon in the last years. A branch of the literature has focused the attention particularly on the effectiveness of capital controls -‐when in place, in limiting the volume of flows. Although studies on this argument began in the late nineties, they lacked of reliable data to draw robust conclusions. In this sense, the Great Recession acted as an input to fill this gap, stimulating the creation of new indexes to perform econometric analyses. Exploiting new datasets, Binici, Hutchison and Schindler (2009) have assessed the effectiveness of capital controls on three typologies of financial flows, namely debt securities, FDI and equity-‐like instruments on a panel of 74 countries in the period 1995–2005. By disaggregating data between inflow and outflow, they demonstrated the uselessness of aggregate estimates to capture the true intensity and reliability of controls. They found statistically significant results only for outflow controls, while inflows’ did not result to be successful.
An aspect that was not covered in their research concerned the effectiveness of controls in limiting flows of financial derivatives, due to lack of data1. Financial derivatives played an important role during the Global Crisis and represent an important aspect of today’s finance. Providentially, a new released dataset (Fernandez, Klein, Rebucci, Schindler &Uribe, 2015) on capital controls bridges this gap, allowing assessing the effectiveness of controls on financial derivatives flows, which is the aim of this paper. I test the effectiveness of controls on disaggregated financial derivatives flows on a sample of 23 high-‐income countries during the period 1996-‐2011. Panel methods and fixed effects will be utilized to assess the validity of the model, both in the version proposed by Binici, Hutchison and Schindler (2009) as with another specification. The paper concludes by providing direction for future researches. The remainder of the paper is organized as follows. Section II provides an overview of the academic debate over capital controls, considering also the role of financial derivatives during the global crisis. Section III extensively describes dataset and methodology, while Section IV presents the results of the research. Finally, section V concludes.
1 They also pointed out that this category of flows accounted for only 4% of total assets and liabilities in the sample period (1995-‐2005). However, this is not properly true; only a few countries (high-‐ income) in the dataset they used (Lane & Milesi-‐Ferretti 2007) registered assets and liabilities for financial derivatives products, masking the effective entity of such flows.
II – LITERATURE REVIEW Capital controls are regulations on capital flows that shelter from a number of risks associated with with financial integration, such as currency risk, capital flight, financial fragility, contagion, and sovereignty (Grabel, 2003). Yet, before the Great Recession of 2008-‐2009, both academics as international financial institutions generally agreed in suggesting the removal of capital controls; the underlying ratio was that capital account liberalization contributes to the development of financial markets, which, in turn, positively stimulates economic development. Financial liberalization affects financial development by providing abundance of capitals while reducing their costs (Chinn & Ito, 2005). Moreover, it also increases the efficiency of the financial system by stimulating competition and reforms (Stiglitz, 2000). On the negative side, Saborowski, Sanya, Weisfeld, & Yepez, (2014) pointed to local and global misallocation of resources and global imbalances (through undervalued exchange rates) as implicit effects of capital controls. Moreover, Aizenman & Parischa (2013), drawing from a vast branch of literature, reaffirm that controls can be part of the regulation of the domestic financial sector that constitute financial repression, allowing governments to reduce borrowing costs and divert savings on preferred sectors of the economy. Yet, since the Asian financial crisis in the late nineties, some have suggested utilizing “soft capital controls” in order to discourage unstable capital (“hot money”) to permeate –and suddenly leave, the domestic financial systems. This argument has seen a revival in the aftermath of the Great Recession. Large flows of capitals went rapidly in and out emerging markets economies –particularly, raising concerns about overheating, foreign exchange valuation, financial stability and macroeconomic volatility (Aizenman & Parischa, 2013). This has brought the IMF to loose its position and academics to investigate whether controls on capitals, under certain situations, can be helpful to mitigate risks associated with flows. Ostry et al. (2010) investigate whether implementing controls on capital inflows before a
financial crisis moderate the subsequent decline in output during the crisis. Their results suggest that emerging economies with greater capital controls on inflows experienced lower decline in output growth rates during the crisis. However, there is not general consensus over this issue. Blundell-‐Wignall & Roulet (2013), for instance, replicated Ostry’s results applying different econometrics techniques, suggesting that his findings were not robust enough to make such strong claims. Opponents of capital controls have also argued that they are not effective in stemming the volume of flows (from Aizerman & Parischa, 2013). This argument has brought a branch of the literature to investigate this argument. Before 2009, studies showed ambiguous results and utilized aggregate controls’ measures (see, for instance, Cardenas & Barrera, 1997; Cardoso & Goldfajn, 1998; Montiel & Reinhart, 1999; Lane & Milesi-‐Ferretti, 2003). With the development of more detailed indexes on capital controls (such as Schindler, 2009) new researches have been able to disaggregate data and find more robust and unequivocal results. As stated in the introduction, Binici, Hutchinson and Schindler (2009) discovered that controls over debt securities, equity instruments and FDI are effective in limiting outflows but inflows; they have not been able, however, to assess their effectiveness in stemming financial derivatives’ flows, due to lack of data on related controls. Financial derivatives are financial instruments whose payoff derives from the value of another underlying asset (Sundaram & Das, 2011), such as financial assets, commodities, exchange and interest rates among others. Financial derivatives are used and traded for a number of reasons, such as risk management, hedging, arbitrage between markets and speculation (Heath, 1998). They have positively contributed to growth by reducing the costs of finance (Bergen, Molyneux, Wilson, 2012), benefiting both industrialized as developing countries2. However, they have also encouraged investors to trade in risky markets, altering the perception of risk and discouraging assertive diligence. The crisis showed the detrimental effects of derivatives and has raised questions 2 See, for example, ‘Derivatives and Development”, The Economist, January 2009
about the their misuse. Prior the crisis some authors (see Allen & Carletti, 2005, for instance) already expressed the possibility that credit risk transfer (from banks in this case) could have increased the risk of crisis, leading to contagion between different sectors and economies. Subsequently, Nijskens and Wagner (2010) demonstrated the validity of that assumption in the context of the Great Financial Crisis. Although consensus over the negative impact of derivatives is not homogeneous, derivatives are, nonetheless, blamed for their complexity and opaqueness (Willke, Becker & Rostasy, 2013). To partly mitigate this problem, the IMF Committee of Balance of Payment Statistics already in 1997 suggested including financial derivatives transfers in the Balance of Payment. However, only a few countries –mostly high-‐income, have published such data. Due to the opaqueness and hypothetical problems brought by the unregulated market of derivatives, a number of countries have also placed –and eventually lifted, some legal barriers limiting their flows. What is it interesting is to assess is whether such de jure restrictions have worked in practice.
III – DATA AND METHODOLOGY
The basic econometric model utilized to answer this question, as proposed by Binici et al (2009), is based on balanced panel data and fixed effect techniques. The baseline regression equation from which I derive the result estimates is the following:
where i and t denote, respectively, country and year, Capital Flow and Capital Control are disaggregated between derivatives’ inflow and outflow and presented separately in two different regressions, whereas X is a vector of control variables that does not change between inflow and outflows. Two sets of controls are utilized;
the first exploits the same variables used by Binici et al (2009). The second has been chosen to best reflect the determinants of derivatives’ flows, which partially differ from debt securities, equity instruments and FDI. The dependent variable measuring the volume of financial derivatives’ assets (inflows) and liabilities (outflows) is extrapolated from an uploaded version of the Lane and Milesi-‐Ferretti (2007) dataset that lasts until 2011. Unfortunately, only a few high-‐income countries registered such transfers, explaining why the panel is restricted to 23 high-‐income states (a list of the countries in the dataset is presented in Table 1). Nonetheless, it is still possible to make some sort of comparison with the results found by Binici et al (2009), since they also perform a regression by dividing their sample on the basis of the World Bank income categorization, separating thus high-‐income countries from others less developed. The independent variable measuring the extent of legal controls over disaggregated flows of financial derivatives comes from a new-‐released dataset on capital controls developed by Fernandez, Klein, Rebucci, Schindler and Uribe (Jan. 2015). Drawing from the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions and from the dataset presented by Schindler (2009), they categorized both inflows and outflows of ten categories of assets for 100 countries in the period 2005-‐2013. The variables of interest dei and deo, accounting for derivatives inflows and outflows restrictions respectively, are discrete numerical variables ranging between 0 and 1 passing through quartiles, with higher values indicating more restrictions. A first set of control variables is taken from the Binici et al (2009) research, who rely on the existing literature of the determinants of capital flows for their choice. Such variables are, namely, GDP per capita, Institution Quality (measured as the average of six indicators), Trade Openness (total exports and imports to GDP), Private Credit(Banks) (Private Credit by Deposit Money Banks to GDP), Stock Market
Cap. (Stock Market Capitalization to GDP) and Natural Resources (Rents from Natural Resources exports to total exports3). The second set of control variables keeps only two of original variables used by Binici et al, namely GDP per capita and Stock Market Cap.. This because the former is a good proxy of economic development that can influence the level of cross-‐borders asset holdings (Lane & Milesi Ferretti, 2003), while the latter is a good proxy of financial sector development. As argued by the authors, “financial sector development facilitates international capital flows because deeper domestic financial markets and a more sophisticated financial infrastructure offer a broader array of channels and instruments through which capital can be allocated”; it follows that such variable should be significant also for financial derivatives flows. A second variable accounting for financial development -‐Private Credit(Others), extends the one used by the authors (Private Credit by Deposit Money Banks to GDP) to consider also private credit to other financial institutions (corporations) besides banks, such as leasing companies, money lenders, insurance corporations, pension funds, and foreign exchange companies. This because also the latters are extensively engage in derivatives’ markets. Instead of proxy for institutional quality –which is quite homogeneous among high-‐income countries and does not directly affect derivatives flows, I consider a variable accounting only for the Regulatory Quality of the considered markets, measuring the perceptions of the burdens imposed by excessive regulations in areas such as foreign trade and business development, the extent of bank supervision and more –higher values correspond to better perceptions (Dahlberg, Stefan, Sören Holmberg, Bo Rothstein, Felix Hartmann & Richard Svensson, 2015). The last variable Flows to GDP also extends the one used by the authors (Trade Openness), by including the weighted sum of foreign direct investment, portfolio investments, income payments to foreign nationals and trade as a percentage of GDP4. The variable accounting for natural resources revenues has 3 For an accurate, theoretical explanation for this choice, see Binici et al, 2009, p. 8-‐9. 4 For a detailed description of this variable, see the KOF index of globalization from which this variable has been taken
been dropped due to the lack of meaning and direct link with financial derivatives flows. Variables’ sources and descriptive statistics are presented in Table 2 and 3 respectively5.
IV -‐ RESULTS Table 4 presents the results of the regression using the first set of control variables. Its explanatory power is relevant, with the R-‐square ranging from around 0.61 for assets (inflows) to 0.54 for liabilities (outflows). Overall, the results exhibit similar coefficients compared to Binici et al’s (2009) research on debt securities, equity instruments and FDI. Yet, a remarkable difference is present. While they found that controls for all those flows are effective only in stemming outflows, Table 4 shows the opposite for financial derivatives. Controls on inflows (assets) have a statistically significant coefficient at 95%, while the ones on outflows, though expressing the right, negative sign, are not significant. This means that policymakers are successful in limiting foreigners from acquiring derivatives products from the domestic market but are not effective in preventing the domestic sphere from engaging in derivatives’ acquisition. This is problematic since it is the latter that can cause problems to the domestic markets by transferring systemic risk from abroad, as it has been the case during the Global Crisis. This concern is reflected by the frequency with which controls on liabilities have been imposed. Figure 1 depicts the pattern of controls for the full sample during the considered period. Eleven countries out of twenty-‐three imposed controls on liabilities (outflows) whereas only six raised barriers on assets (inflows). In terms of control variables, GDP Per Capita is the only one highly significant for both inflows as outflows. Trade Openness and Private Credit(Banks) have the right,
5 Please, note that many of the variables (namely, Financial Derivatives Assets, Financial Derivatives Liabilities, GDP per capita, Trade Openness, Rent from Natural Resources, Stock Market Capitalization to GDP, Private Credit to Deposit Money Banks and Other Institutions and the Weighted Sum of Trade, FDI, Portfolio Investment and Income payment to Foreign Nationals) have been transformed in logarithmic to perform the econometric analysis.
positive sign but are significant only with regards to outflows. The negative sign for Stock Market Cap., though surprising, is in line with the results of Binici et al (2009); they discovered that an increase in this variable reduces flows of debt securities, though equities and FDI flows are positively stimulated. Lastly, as suggested in Section 3, both Institutional Quality as Natural Resources are insignificant. Moreover, they exhibit a negative sign, which, though not properly logical, has been found also by Binici et al (2009). Table 5 shows the results of the regression with the second set of variables. The explanatory power of both the regression for inflow as for outflow is greater than in the previous specification, with an R-‐squared reaching 0.69 with respect to assets and 0.651 for liabilities. Similarly to Table 4, only controls on inflows are significant, but its coefficient is bigger in magnitude than before. Specifically, by lowering the controls from 1.0 to 0.5, derivatives’ inflows (assets) would increase by 120 percent. Conversely to Table 4, all the control variables are significant except for the proxy of Regulatory Quality, which -‐nevertheless, exhibits a positive sign. Considering GDP Per Capita, a 1 percent increase of both its coefficients raises the in/out flows of derivatives by more than 5 percent. The coefficient of Stock Market Cap. is still negative, confirming this important, inverse relation between this measure and flows of derivatives –and debt securities. Extremely relevant becomes the weighted sum of trade, FDI, equities and payments from foreigners to GDP. The magnitude of its coefficients is remarkable (a 1 percent increase leads to a growth of almost 5 percent and 7.2 percent in inflows/outflows, respectively) and significant at 99.9%. This because derivatives can go in tandem with such flows, hedging risks and alimenting speculation and arbitrage. Not surprisingly, also the coefficients for Private Credit(Others) are significant for both inflows and outflows. This because not only banks, but other financial institutions such as pension funds make considerable usage of financial derivative markets.
V -‐ CONCLUSION
In this paper, I have extended the research made by Binici et al (2009) on the effectiveness of capital controls on disaggregated flows of debt securities, equity-‐ like instruments and FDI to financial derivatives. This analysis has been possible thanks to a new-‐released dataset on capital controls that provides data also on financial derivatives’ legal restrictions. The econometric model has been estimated using panel methods and fixed effect techniques on a sample of 23 high-‐income countries during 1996-‐2011. Two different sets of control variables have been used in the regressions; the first is based on Binici et al (2009) research, whereas the second has been chosen considering more relevant determinants of financial derivatives acquisitions, resulting to be more appropriate and consistent in the context of the current research. The findings of this analysis contribute to the existing literature in various ways. First, contrary to debt, equity and FDI flows, legal controls on financial derivatives are effective in stemming inflows (assets) rather than outflows (liabilities). This can be alarming for policymakers since it is the acquisition of risky derivatives products from foreign countries that can cause problems to the domestic financial markets – as it happened during the Global Crisis. Second, the inverse relation between stock market capitalization to GDP and debt securities’ flows has been evidenced also for financial derivatives. Neither I nor Binici et al (2009) have found a clear explanation for this relation, which is left to future researches. Lastly, though the results appear to be robust, further analysis can take in consideration the controls and flows’ interaction between pairs of countries, in order to assess whether the total volume of derivatives’ flows is attenuated by effective, simultaneous controls on inflows. If found the latter to be true, countries could engage in simultaneous inflows controls to obvert the inefficacy in stemming outflows.
BIBLIOGRAPHY
2011a, The Multilateral Aspects of Policies Affecting Capital Flows (Washington, DC: International Monetary Fund), October Aizenman, Joshua & Pasricha, Gurnain Kaur, 2013. "Why do emerging markets liberalize capital outflow controls? Fiscal versus net capital flow concerns," Journal of International Money and Finance, Elsevier, vol. 39(C), pages 28-‐64. Allen N. Bergen, Philip Molyneux, John O. S. Wilson (2012), The Oxford Handbook of Banking, Oxford University Press. Allen F, Carletti E (2006), Credit risk transfer and contagion, Journal of Monetary Economy 53(1):80–111. Binici, Mahir & Hutchison, Michael & Schindler, Martin, 2010. "Controlling capital? Legal restrictions and the asset composition of international financial flows," Journal of International Money and Finance, Elsevier, vol. 29(4), pages 666-‐684, June. Blundell-‐Wignall Adrian and Roulet Caroline, 2013, Capital controls on inflows, the global financial crisis and economic growth: Evidence for emerging economies, OECD Journal: Financial Market Trends, Volume, 2. Cardenas, Mauricio & Barrera, Felipe, 1997. "On the effectiveness of capital controls: The experience of Colombia during the 1990s," Journal of Development Economics, Elsevier, vol. 54(1), pages 27-‐57, October. Cardoso Eliana & Goldfajn Ilan, 1998. "Capital Flows to Brazil: The Endogeneity of Capital Controls," IMF Staff Papers, Palgrave Macmillan, vol. 45(1), pages 161-‐202, March. Chinn, Menzie and Hiro Ito. What Matters for Financial Development? Capital Controls, Institutions, and Interactions? Journal of Development Economics, 81, 2006, 163-‐192. Dahlberg, Stefan, Sören Holmberg, Bo Rothstein, Felix Hartmann & Richard Svensson. 2015. The Quality of Government Basic Dataset, version Jan15. University of Gothenburg: The Quality of Government Institute, http://www.qog.pol.gu.se Dreher, Axel (2006): Does Globalization Affect Growth? Evidence from a new Index of Globalization, Applied Economics 38, 10: 1091-‐1110. -‐ Updated in: Dreher, Axel,
Noel Gaston and Pim Martens (2008), Measuring Globalisation – Gauging its Consequences (New York: Springer). Fernández & Michael W. Klein & Alessandro Rebucci & Martin Schindler & Martín Uribe, 2015. "Capital Control Measures: A New Dataset," NBER Working Papers 20970, National Bureau of Economic Research, Inc. Grabel, Ilene. (2003) Averting Crisis? Assessing Measures to Manage Financial Integration in Emerging Economies. Cambridge Journal of Economics 27 (3):317-‐ 336. Heath R., The Statistical Measurement of Finanacial Derivatives, 1998, IMF Statistic Department, Working Paper Series Lane Philip R. & Milesi-‐Ferretti G.M. 2003. "International Financial Integration," Trinity Economics Papers 20031, Trinity College Dublin, Department of Economics. Lane Philip R. & Milesi-‐Ferretti G.M., 2007, "The External Wealth of Nations Mark II", Journal of International Economics, November 2007 Nijskens, Rob; Wagner, Wolf (Jun 2011), Credit risk transfer activities and systemic risk: How banks became less risky individually but posed greater risk to the financial system at the same time, JOURNAL OF BANKING & FINANCE Volume: 35 Issue: 6 Pages: 1391-‐1398. Ostry, J.D., A.R. Ghosh, K. Habermeier, M. Chamon, M.S. Qureshi, and D.B.S. Reinhardt, 2010, “Capital Inflows: The Role of Controls”, IMF Staff Position Note 10/04, 19 February; Washington: International Monetary Fund Reinhart, Carmen & Montiel, Peter, 1999. "Do capital controls influence the volume and composition of capital flows? Evidence from the 1990s," MPRA Paper 13710, University Library of Munich, Germany. Saborowski Christian & Sanya Sarah & Weisfeld Hans & Yepez, Juan 2014. "Effectiveness of Capital Outflow Restrictions," IMF Working Papers 14/8, International Monetary Fund. Schindler Martin, 2009. "Measuring Financial Integration: A New Data Set," IMF Staff Papers, Palgrave Macmillan, vol. 56(1), pages 222-‐238, April. Schindler Martin, 2009. "Measuring Financial Integration: A New Data Set," IMF Staff Papers, Palgrave Macmillan, vol. 56(1), pages 222-‐238, April.
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TABLES & FIGURES Table 1 – List of countries in the dataset Australia
France
Portugal
Austria
Greece
Singapore
Belgium
Ireland
Spain
China: Hong Kong S.A.R.
Italy
Sweden
Cyprus
Korea, Republic of
Switzerland
Czech Republic
Japan
United Kingdom
Denmark
Netherlands
United States
Finland
New Zealand
Table 2 – Variables description and sources
Variable Description Source Financial Derivatives Flows dei / deo GDP Per Capita Trade Openness Natural Resources Private Credit (Banks) Stock Market Cap. Institutional Quality
Private Credit (Banks&Others) Regulatory Quality
Flows to GDP
Financial derivatives flow (per capita, in US Dollar)
Lane & Milesi-‐Ferretti (2007)
Index of Controls over Financial Derivatives (Range: 0-‐1, from most to least regulated) GDP per capita with constant 2011 US Dollar Total Export and Import/GDP
Fernandez, Klein, Rebucci, Schindler & Uribe ( 2015)
Sum of Fuel, Ores and Metal Export/Total Export Private Credit by Deposit Money Bank/GDP Stock Market Capitalization/GDP Average of the Percentile Rank of Six Indicators: Voice and Accountability, Political Stability, Government Effectiveness, Regulatory Quality, Rule of Law, Control of Corruption (Range: 0-‐100, where a higher score means better institutions) Private Credit by Deposit Money Bank and Other Financial Institutions/GDP Regulatory Quality Index -‐
Weighted sum of Trade (22%), FDI (27%), Portfolio Investment (24%) and Income Payment to Foreign Nationals (27%)/GDP
Table 3 – descriptive statistic for all the variables
World Bank Development Indicators (World Bank) World Bank Development Indicators (World Bank) World Bank Development Indicators (World Bank) Financial Structure Dataset (World Bank) Financial Structure Dataset (World Bank) Kaufman, Kraay & Mastruzzi (2006)
International Financial Statistics (IMF) Dahlberg, Stefan, Sören Holmberg, Bo Rothstein, Felix Hartmann & Richard Svensson. 2015 Dreher, Gaston, Martens (2008)
Figure 1 – The Composition of Financial Derivatives Controls, 1996-‐2011
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