Financial Connectedness and Financial Trade Openness

Abstract

What determines a country’s financial trade openness? Because of the importance of financial services in the economy, many governments want to attract trade in financial services, including cross-border trade and FDI in the financial services industry. Therefore, it is commonly assumed that the more the financial sector is linked to the rest of the economy, the more a country will open up trade in financial services. However, my analysis finds that the reverse is true. The more connected the financial industry to the rest of the economy, the more a country restricts its financial trade openness. I argue that a higher degree of financial connectedness exposes more domestic financial firms to competition with foreign financial firms, leading governments to selectively liberalize the financial industry through entry restrictions. To test my argument, I have created two original datasets on financial connectedness and financial trade restrictions in 51 countries. I find the cross-country variation in the degree of financial connectedness to be the key factor determining variation of financial trade openness around the world.