Capital Flows, De Jure vs. De Facto Financial Openness

Abstract

This paper analyzes the relationship between de jure financial openness, and de facto financial openness. I use the Chinn-Ito index to proxy a country's legal arrangements regarding external transactions, and examine its relationship to actual realized international capital flows of various types and direction. I use a long panel, from 1980 until the start of global financial crisis, and include a large group of developed and developing countries. Linear panel data estimation methods, and two other regression models are used to explicitly examine the interaction of country attributes with policy. The first model uses interaction terms between legal financial openness and financial development or institutional quality to gauge whether these development attributes amplify or dampen the effect of legal opening on realized flows. The second model uses dummy variables for country sub-groups to assess whether threshold levels of development are important. I find that in general the relation between legal openness and realized international financial flows is weak. Some assets do respond to policy, others seem unaffected. In particular, the relationship is more powerful for financially developed countries. Using time series econometric methods to further investigate the connection between financial openness, domestic financial development and international financial integration, I look at the bank lending rate for five Asian economies. Rather than parity or convergence, I examine variance decompositions to assess the proportion of outside influence on domestic lending rates. The experience of Japan, South Korea and Indonesia support the conclusions arising from the panel analysis that greater financial development enhances integration.