Does Financial Openness Promote Economic Integration?

Abstract

The steady expansion of financial flows across the borders and the rapid increase in the number of regional economic integration agreements are two of the most evident aspects of globalization in the 1990s. The purpose of this chapter is to study the link between the two. In particular, we estimate the extent to which financial openness promotes regional economic integration in Europe and the Commonwealth of Independent States (CIS). We focus on two specific dimensions of the integration process: the convergence of per capita incomes across countries in a regional cluster and the intensity of trade in goods and services between countries. With regard to financial openness, we delineate between capital account liberalization and international financial integration. These two concepts have often been used interchangeably in the literature but, in fact, they represent a mean-goal relationship.1 Capital account liberalization is the process of lifting administrative or legal restrictions on capital movements — hence, creating the necessary conditions for the integration of the domestic financial system into the global market. International financial integration, instead, refers to the actual volume of capital flows that take place across the borders. Thus, financial openness is essential to achieve international financial integration; however, the former does not necessarily lead to the latter. Operationally, the analysis in this chapter will employ different proxies to measure international financial integration: (i) an index of capital account liberalization; and (ii) the volume of portfolio-based and equity-based capital flows.