How do structural reforms and, in particular, financial sector reforms affect macroeconomic volatility and resilience? In principle, financial reforms should help buffer economies against the effects of adverse shocks, facilitate adjustment to such shocks, and thereby foster greater risk sharing at the economy-wide level. Intuitively, a financial sector that efficiently allocates credit can provide firms with liquidity and reduce inefficient closures when shocks occur (Bernanke and Gertler, 1989; and Kiyotaki and Moore, 1997). To address what is in essence an empirical issue, Figure 7.1 shows how output volatility (top panel) and the frequency of “sudden stops” (bottom panel) vary with the level of financial liberalization.17 The results suggest that countries with a relatively liberalized domestic financial sector seem to enjoy lower macroeconomic volatility and experience a lower incidence of sudden stops, while the association between external capital account liberalization and macroeconomic volatility/crisis propensity appears to be weak. Of course, just as the growth effects of structural reforms depend critically on the sequencing strategy pursued, so too the above volatility/crisis risk results also reflect reform sequencing. Specifically, as shown in Table 7.1, volatility and crisis risk are low when the domestic financial sector and the external capital account are both relatively liberalized, while volatility and crisis risk are high when the external capital account is relatively liberalized but domestic financial sector liberalization is low. The results in Figure 7.1 thus would seem to aggregate very different macro-volatility profiles from domestic financial reform and external capital account liberalization, which depend critically on the sequencing strategy pursued.
Financial Sector Reforms, Output Volatility, and Capital Account Crises
Financial Sector Reforms, Output Volatility, and Capital Account CrisesSources: IMF staff estimates based on Penn World Tables version 6.2 and World Economic Outlook database.Note: Upper panel. The output volatility portrayed on the y-axis is the standard deviation of within-country growth rates measured as deviations from country means over the sample period net of a global growth trend. These growth rates have been obtained from a panel regression of annual GDP growth on country fixed effects (to remove country averages) and year fixed effects (to remove global trends). The panel shows the difference in output volatility between low-reform (below median) years and high-reform (above median) years within countries.Lower panel. The panel shows the difference in the frequency of capital account crises (i.e., sudden stops in capital flows) between low-reform (below median) years and high-reform (above median) years within countries. The crises episodes were selected following the methodology in Chamon, Manasse, and Prati (2007).Financial Sector Reforms, Output Volatility, and Capital Account Crises
Financial Sector Reforms, Output Volatility, and Capital Account CrisesSources: IMF staff estimates based on Penn World Tables version 6.2 and World Economic Outlook database.Note: Upper panel. The output volatility portrayed on the y-axis is the standard deviation of within-country growth rates measured as deviations from country means over the sample period net of a global growth trend. These growth rates have been obtained from a panel regression of annual GDP growth on country fixed effects (to remove country averages) and year fixed effects (to remove global trends). The panel shows the difference in output volatility between low-reform (below median) years and high-reform (above median) years within countries.Lower panel. The panel shows the difference in the frequency of capital account crises (i.e., sudden stops in capital flows) between low-reform (below median) years and high-reform (above median) years within countries. The crises episodes were selected following the methodology in Chamon, Manasse, and Prati (2007).Financial Sector Reforms, Output Volatility, and Capital Account Crises
Financial Sector Reforms, Output Volatility, and Capital Account CrisesSources: IMF staff estimates based on Penn World Tables version 6.2 and World Economic Outlook database.Note: Upper panel. The output volatility portrayed on the y-axis is the standard deviation of within-country growth rates measured as deviations from country means over the sample period net of a global growth trend. These growth rates have been obtained from a panel regression of annual GDP growth on country fixed effects (to remove country averages) and year fixed effects (to remove global trends). The panel shows the difference in output volatility between low-reform (below median) years and high-reform (above median) years within countries.Lower panel. The panel shows the difference in the frequency of capital account crises (i.e., sudden stops in capital flows) between low-reform (below median) years and high-reform (above median) years within countries. The crises episodes were selected following the methodology in Chamon, Manasse, and Prati (2007).Financial Sector Reforms, Output Volatility, and Capital Account Crises
Financial Sector Reforms, Output Volatility, and Capital Account Crises
| External Capital Account Liberalization | |||
|---|---|---|---|
| High | Intermediate | Low | |
| Output volatility (Percentage points) | |||
| Domestic financial sector liberalization | |||
| High | 2.8 | 4.6 | 3.1 |
| Intermediate | 3.6 | 5.0 | 4.2 |
| Low | 8.1 | 6.4 | 4.6 |
| Frequency of sudden stops (Percentage points, annual basis) | |||
| Domestic financial sector liberalization | |||
| High | 4.0 | 3.9 | 5.6 |
| Intermediate | 6.2 | 3.8 | 5.5 |
| Low | 6.7 | 6.5 | 4.7 |
Financial Sector Reforms, Output Volatility, and Capital Account Crises
| External Capital Account Liberalization | |||
|---|---|---|---|
| High | Intermediate | Low | |
| Output volatility (Percentage points) | |||
| Domestic financial sector liberalization | |||
| High | 2.8 | 4.6 | 3.1 |
| Intermediate | 3.6 | 5.0 | 4.2 |
| Low | 8.1 | 6.4 | 4.6 |
| Frequency of sudden stops (Percentage points, annual basis) | |||
| Domestic financial sector liberalization | |||
| High | 4.0 | 3.9 | 5.6 |
| Intermediate | 6.2 | 3.8 | 5.5 |
| Low | 6.7 | 6.5 | 4.7 |
Figure 7.2 comes to the volatility issue from a different angle, by examining whether liberalization of the domestic financial sector helps to buffer economies against terms of trade shocks, a key source of volatility in low- and middle-income countries. Results suggest that, in countries with more liberalized domestic financial sectors, growth rebounds faster after a negative terms of trade shock (Figure 7.2). Results reported in Ramcharan (forthcoming) suggest that the magnitude of the benefit from reform is substantial: after a decline in the terms of trade of 10 percentage points, a one standard deviation difference in the domestic financial sector liberalization index is associated with a cumulative income per capita growth that is 1.3 percentage points higher over a five-year period. The enhanced resilience provided by domestic financial sector liberalization extends to a variety of other real shocks—such as windstorms, floods, and earthquakes (Ramcharan, 2007)—where greater credit availability provides a key channel buffering the aggregate output effects from such shocks.
Terms of Trade Shocks and the Financial Sector
Source: IMF staff calculations.Note: This figure plots median growth rates in the three years following a negative terms of trade shock. A negative terms of trade shock for each country is defined as a decline of one or more standard deviations in the growth in the terms of trade. The figure shows separately the growth rates for country-year pairs above and below the median level of banking sector liberalization. These growth rates have been obtained from a panel regression of annual GDP growth on country fixed effects (to remove country averages) and year fixed effects (to remove global trends).Terms of Trade Shocks and the Financial Sector
Source: IMF staff calculations.Note: This figure plots median growth rates in the three years following a negative terms of trade shock. A negative terms of trade shock for each country is defined as a decline of one or more standard deviations in the growth in the terms of trade. The figure shows separately the growth rates for country-year pairs above and below the median level of banking sector liberalization. These growth rates have been obtained from a panel regression of annual GDP growth on country fixed effects (to remove country averages) and year fixed effects (to remove global trends).Terms of Trade Shocks and the Financial Sector
Source: IMF staff calculations.Note: This figure plots median growth rates in the three years following a negative terms of trade shock. A negative terms of trade shock for each country is defined as a decline of one or more standard deviations in the growth in the terms of trade. The figure shows separately the growth rates for country-year pairs above and below the median level of banking sector liberalization. These growth rates have been obtained from a panel regression of annual GDP growth on country fixed effects (to remove country averages) and year fixed effects (to remove global trends).Sectoral evidence also shows that those manufacturing sectors more exposed to terms of trade shocks— specifically, those that use relatively more imported intermediate inputs in production—experience a growth deceleration, following a negative terms of trade shock, which is relatively smaller in countries with more liberalized domestic financial systems. Specifically, Table 7.2 illustrates regressions of the change in sectoral output growth in the three years following a negative terms of trade shock relative to the three years preceding the shock. An episode of a negative terms of trade shock is defined as a year during which the terms of trade deteriorates by more than 10 percent relative to the previous years (considering alternative thresholds does not affect the main result). During such episodes, annual manufacturing output growth on average declines by 5 percentage points over a three year period.
Financial Sector Reforms and Resilience to Terms of Trade Shocks
Financial Sector Reforms and Resilience to Terms of Trade Shocks
| Dependent Variable: Change in Sectoral Output Growth in the Three Years Following a Terms of Trade Shock |
(1) | (2) | (3) |
|---|---|---|---|
| Domestic financial liberalization index interacted with a measure of imported input intensity (t–3) | 0.181*** | 0.229*** | 0.183*** |
| (0.056) | (0.052) | (0.059) | |
| Private credit/GDP interacted with a measure of imported input intensity (t–3) | -0.068 | ||
| (0.044) | |||
| Growth rate of terms of trade interacted with a measure of imported input intensity (t) | -0.185 | ||
| (0.56) | |||
| Log output share (t–3) | -0.006 | -0.006 | -0.006 |
| (0.009) | (0.009) | (0.009) | |
| Observations | 995 | 978 | 995 |
| R-squared | 0.13 | 0.14 | 0.13 |
Financial Sector Reforms and Resilience to Terms of Trade Shocks
| Dependent Variable: Change in Sectoral Output Growth in the Three Years Following a Terms of Trade Shock |
(1) | (2) | (3) |
|---|---|---|---|
| Domestic financial liberalization index interacted with a measure of imported input intensity (t–3) | 0.181*** | 0.229*** | 0.183*** |
| (0.056) | (0.052) | (0.059) | |
| Private credit/GDP interacted with a measure of imported input intensity (t–3) | -0.068 | ||
| (0.044) | |||
| Growth rate of terms of trade interacted with a measure of imported input intensity (t) | -0.185 | ||
| (0.56) | |||
| Log output share (t–3) | -0.006 | -0.006 | -0.006 |
| (0.009) | (0.009) | (0.009) | |
| Observations | 995 | 978 | 995 |
| R-squared | 0.13 | 0.14 | 0.13 |
The results imply that domestic financial liberalization has an economically significant impact on relative output growth following a negative terms of trade shock. For instance, a sector importing about 30 percent of its inputs will experience an output growth deceleration (relative to the output growth deceleration of a sector that imports 20 percent of its inputs) that is about 0.5 percentage point smaller in a country with a banking sector reform index that is one standard deviation higher. These results confirm the role of financial development in dampening the adverse effects of financial fragility (Raddatz, 2006). This evidence is consistent with existing theories emphasizing the role of financial frictions in propagating economic fluctuations (Bernanke and Gertler, 1989; Holmstrom and Tirole, 1997; and Aghion and others, 2005), as well as with theories that describe the mechanisms through which well-functioning financial systems have a positive impact on the development process (Banerjee and Newman, 1991; and Greenwood and Jovanovic, 1990).
Domestic financial sector liberalization also enhances the resilience of the economy to financial shocks. Specifically, the market structure of the banking system is often a key component of financial sector reforms. A perennial question in finance is whether policies that promote competition in the banking sector might also influence the resilience of the financial system to liquidity shocks (Carletti and Hartmann, 2002). The evidence suggests that, after a 1 percentage point increase in foreign interest rates, economies that score at the 75th percentile on the banking sector competition subindex enjoy a cumulative income per capita growth, over a five-year period, that is 3 percentage points higher than economies at the median level of banking competition (Ramcharan, forthcoming). This buffering role of banking sector competition is likely to reflect risk diversification benefits from fewer restrictions on the number and geographical location of bank branches (see Box 7.1).
Banking Sector Competition and Macroeconomic Stability
Do policies that promote competition in the banking sector compromise financial and macroeconomic stability (Carletti and Hartmann, 2002)? This question has taken on increased resonance with the recent banking crises in the United States, but has long featured in debates over banking competition and stability. After the severe banking crises of the 1930s in the United States, most states eventually restricted competition, barring the entry of banks chartered in other states in order to preserve stability. Modern debates, driven in part by periodic banking crises in emerging markets over the last two decades, also focus on the role of entry barriers and similar regulations in making the financial sector more resilient to external liquidity and other shocks (Kaminsky and Reinhart, 1999; and Mishkin, 2001).
In particular, allowing banks to earn monopoly rents can limit excessive risk taking, especially in response to the moral hazard related to deposit insurance and other public guarantees (Allen and Gale (2000)). Extending this intuition, Dell'Ariccia and Marquez (2006) model the idea that lending standards can decline as banks compete to gain market share during booms. The resulting expansion of credit to potentially low-quality borrowers can make the banking system more vulnerable to aggregate liquidity shocks. However, Boyd and De Nicolò (2005) argue that because monopolies charge higher interest rates on loans, borrowers are likely to adjust their investments by taking on more risk. As a result, interest rate increases and other aggregate shocks might lead to wider default among borrowers in monopolistic banking systems. Also, while regulatory entry barriers can increase the rents of incumbent banks, they limit the risk diversification opportunities of banks across space, potentially increasing the vulnerability of the financial system to liquidity shocks.
To explore the relationship between banking sector competition and the economy's resilience to liquidity shocks, we turn to external interest rate movements. These movements can affect the liquidity available to domestic banking systems, and often influence economic outcomes in developing countries (Di Giovanni and Shambaugh, 2008).1 The evidence consistently suggests that the output cost of external interest rate movements are significantly greater in economies ranked as having more regulatory entry barriers in the banking sector. For two otherwise similar countries, a standard deviation increase in the base interest rate is associated with a 1 percentage point (or 0.25 standard deviations) decline in real per capita output growth for a country with regulations that restrict bank competition. In contrast, for a country classified as having few entry restrictions on banking, a similar increase in the base rate leaves real per capita output growth practically unchanged.
These results are mainly driven by open capital account economies, and bear upon the debate on the link between capital account openness and financial sector stability.2 The pass-through of base rate movements onto the domestic financial system is typically larger in open capital account economies. These economies are also more susceptible to sharp reversals in capital flows when external rates change. In this subsample of countries, a one standard deviation positive interest rate shock is associated with a 2.2 percentage point decline in output growth for countries with regulations that restrict bank entry. There is a slight increase in output growth of about 0.12 percentage points in regulatory environments that favor banking competition. Moreover, when foreign rates increase, higher entry barriers in this subsample are also associated with a higher probability of banking crises, and greater rigidity in domestic deposit rates.3
Taken together, this evidence appears most consistent with those models that suggest that lower entry barriers and policies that promote banking competition might also enhance the resilience of the financial system to external liquidity and other shocks. The results also imply that, in the absence of these domestic financial sector policies, capital account openness might actually increase financial and economic instability.
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1 Neumeyer and Perri (2005) model the business cycle impact of foreign interest rates. In addition to Di Giovanni and Sham-baugh (2008), see also Reinhart and Rogoff (2008) and Reinhart and Reinhart (2001) for evidence on the impact of economic outcomes in financial centers on periphery countries. 2 See the recent survey in Kose and others (2006). 3 Beck and others (2005) also find that competition-friendly regulatory environments are less prone to banking crises.In principle, while there may be a connection between real sector reforms and output volatility, the data do not speak loudly on such a linkage, hence the focus in this section on the association between financial sector liberalization and resilience to shocks.
