Openness and Domestic Financial Liberalization: Which Comes First?

Abstract

We use a new dataset of de jure measures of trade, capital account, product markets, and domestic financial regulation covering 91 countries from 1973 to 2005 to examine the links between openness and domestic financial liberalization. We find strong evidence that trade liberalization is a leading indicator of domestic financial liberalization. This result holds with different data frequencies (from annual to 5-year intervals), estimation methods (OLS and 2SLS), trade liberalization measures (tariff and non-tariff), and after controlling for domestic product market liberalization, whose agriculture component is a robust leading indicator of domestic financial liberalization in low- and middleincome countries. The primacy of trade liberalization is consistent with Rajan and Zingales’s (2003) positive interest-group theory of financial development and McKinnon’s (1991) normative “order of economic liberalization.” The data do not confirm, instead, either of the contrasting implications of these two theories for the sequencing of capital account and domestic financial liberalization.