HOW INTEGRATED are international capital markets? This is clearly an important issue. By allowing countries to borrow and lend money efficiently, open capital markets can provide the same services across countries that they provide within a single economy, allowing more efficient use of funds for investment and improving the allocation of consumption over time. These gains, which are similar to those accruing to individuals from capital markets within a country, were the logic behind the general move toward international financial liberalization since the late 1970s (documented in OECD (1987) and Mathieson and Rojas-Suarez (1990)).
While the potential gains from open international capital markets are clear, measuring the actual level of international capital mobility has proved to be more difficult.1 Among the main measures used in the literature are comparisons of onshore-offshore nominal interest rates and the correlation of saving and investment rates across countries. Tests involving nominal interest comparisons generally indicate a high degree of capital mobility, while those involving savings-investment relationships show relatively low levels.
This uncertainty has revived interest in alternative measures of the openness of international capital markets. One promising avenue, suggested by Obstfeld (1994), involves using consumption patterns across countries as a measure of capital mobility. The logic behind the test is that if capital markets are integrated, consumers will be able to insulate themselves against idiosyncratic disturbances, and hence that consumption across individual countries should be highly correlated with the path of the aggregate across all countries. Using this approach, Obstfeld finds evidence that capital mobility across industrial countries has been rising over time, but that it is still less than perfect.
This paper extends this work on international consumption patterns. As well as looking at a larger set of countries, a somewhat different estimating equation is derived, which takes explicit account of the possibility that part of local consumption depends upon local income. As well as making the results more robust with respect to this type of behavior, this specification also differentiates between two different reasons for capital market failure: excess sensitivity of consumption to local income, and low correlation between changes in home and external consumption adjusted for income. It is useful to distinguish between these two sources of failure, which are not separated in earlier tests, as they have very different implications as to the source of the capital market imperfection. In particular, the former source of capital market failure indicates that the cause is a lack of access to domestic capital markets, whereas the latter source indicates that the cause is a failure to access international capital markets.
The plan of the paper is as follows. Section I provides an overview of some alternative tests of international capital mobility. Section II then describes the proposed test for capital mobility and compares our approach with that taken by Obstfeld. Section III describes the data and presents a discussion of some estimation issues. Sections IV and V discuss results from the full data set, and the European Community,2 respectively. Section VI concludes.
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Tamim Bayoumi is an Economist in the Research Department. He is a graduate of Cambridge and Stanford Universities. Ronald MacDonald was a visiting scholar in the Research Department when this paper was begun. He is now a professor of economics at the University of Strathclyde. The authors thank Peter Clark for useful comments on an earlier draft of this paper.
Recently the European Community renamed itself the European Union. Since it was called the European Community throughout the estimation period involved in this paper, the original name will be used.
Obstfeld (1989) and Tesar (1991). However, recent evidence indicates that saving and investment ratios within countries are generally uncorrelated. Since capital mobility within countries is high, this is consistent with the Feldstein and Horioka assumption (Bayoumi and Rose (1993)).
Individuals should also be able to smooth income in a world of full contingent markets. Atkeson and Bayoumi (1993) provide empirical estimates of the degree to which individuals actually use asset markets to smooth fluctuations in local income in the United States and the European Community.
Indeed, it has one advantage over the Hall formulation, in that it is not necessary to assume that the real interest rate is constant over time in order to derive the result.
This also has the technical advantage that it minimizes the size of the error ϵj.
This can be seen most easily from equation (5). Since λj is less than 1, the sum of the coefficients on foreign consumption and income must be positive: hence, any downward bias in the estimation must reduce the sum of the coefficients.
The OECD countries that are missing are Australia, Iceland, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland, Turkey, and the former Yugoslavia. Of these, only Australia, Sweden, and Switzerland have large economies.
These were the longest periods for which consistent data sets could be produced. In addition, the results in Obstfeld (1994) indicate that international consumption patterns during the Bretton Woods exchange rate regime are rather different from those during the subsequent floating rate regime.
The implicit deflator for total consumption was used to convert nominal income into real income.
There is a well-known problem with ensuring that the covariance matrix is positive definite. This was achieved using the procedure suggested by Newey and West (1987).
This is tested using the u’ZWZ’u statistic, which has a χ2 distribution with degrees of freedom equal to the number of overidentifying restrictions.
As discussed above, the six instruments were the second lags of the growth in real consumption, real income, and the ratio of consumption to income (the saving rate) for the country and the rest of the world. A constant term was included in the regression, to take account of any deviation of the subjective discount rate across regions.
Constant terms are not reported.
The results for those countries for which the restriction is not accepted are generally very similar to those using the unrestricted model.
Austria was not a member of the European Community over the estimation period, but it joined the European Union in 1995.
Similar results were obtained when the sample was limited to long-term members of the European Community (i.e., excluding Greece, Ireland, and the United Kingdom).
For example, France and Italy only removed their capital controls at the end of 1990, as part of the European Community’s single market program.
As this test also assumes that the rate of intertemporal substitution is equal across countries, an alternative interpretation of these results is that it is a variation in this characteristic that is creating these results. However, we find this explanation unlikely for reasons discussed above.