Pakistan Journal of Social Sciences (PJSS)

Vol. 40, No. 4 (2020), pp. 1631-1640

Effect of Openness on Financial Sector Development in Asian

Emerging Markets: A System Dynamic Panel Data Approach
Muhammad Atiq-ur-Rehman (Corresponding author)
Higher Education Department, Punjab Lahore, Pakistan
Email: [email protected]

Saima Liaqat
Lahore College for Women University, Jhang Campus, Pakistan
Email: [email protected]

Sarfaraz Ahmed Shaikh

Indus Center for sustainable development, Karachi, Pakistan
Email: [email protected]

Suleman Ghaffar
PhD Scholar of Public Administration,
School of Government, (GSGSG), University of Utara Malaysia
Email: [email protected]

Abstract:
Openness has become an imperative feature of contemporary economic
systems in this globalized world. Trade and financial openness may
lead to financial sector development in the emerging market economies
(EMEs). A developed financial sector is necessary to control financial
vulnerability and boost economic growth by channeling funds to the
most productive and profitable investments. This study aims at
investigating the impact of trade and financial openness on financial
development in Asian emerging economies. A modern estimation
technique of Arellano-Bover/Blundell-Bond linear dynamic panel data
generalized method of moments (GMM) system is applied considering
seven Asian emerging economies for the period 1999-2019. The
empirical results indicate that both types of openness significantly
contribute to the financial sector development. However, the marginal
effect of financial and trade openness is negative which reflects the
more benefits of openness to the relatively closed economies. Hence,
empirical findings partially support the Rajan and Zingales hypothesis
suggesting a sequential approach towards opening up of trade and
capital accounts instead of simultaneous openness.

Keywords: Openness, Financial Sector Development, Emerging Market

Economies, Panel Data Approach
JEL Classifications Codes: F4, F13, G00, O16

I. Introduction
Openness is the outcome of economic globalization and liberalization. Trade
and financial openness are becoming the imperative features of modern economic
systems. However, emerging economies are generally prone to more risk of financial
catastrophe due to higher macroeconomic volatility and external imbalances. Trade and
1632 Pakistan Journal of Social Sciences Vol. 40, No. 4

financial openness promote financial development by enhancing the ability of the

banking sector to channel funds to the most productive and profitable investment
ventures (Demetriades and Hussein, 1996; Levine, 2003). Financial openness can
alleviate "financial repression1" by raising real interest rates to its market equilibrium.
The efficient financial system enables an economy to achieve higher growth rates through
proper allocation of capital. The developing economies have been restricting a
competitive environment in the financial sector through government regulations and
interventions. The repressed financial system dampens savings and investment because
the rate of return is lower than the competitive market return. In such a situation, the
financial system remains unable to function properly and fails to channel savings to the
lucrative investment Endeavors. The elimination of restrictions on capital flows permits
domestic and foreign investors to diversify their portfolio and to reduce the risk. Hence
financial openness increases the accessibility of funds to the potential investors and make
them able to invest in the profitable projects. Demetriades & Hussein (1996) and Levine
(2003) argue that financial sector development contains a vibrant mechanism to stimulate
long-run growth. Claessens et al. (1998) and Levine (2001) are of the view that financial
openness enhances financial sector development by promoting banking sector efficiency.

Trade openness enables countries to reap the benefits of comparative advantage.

The specialization improves the level of financial intermediation. The comparative
advantage affects the production patterns of a country altering the demand for foreign
finances. Then economies specializing in financially dependent products may have a
higher demand for external finances which will improve the financial intermediation
domestically. On the other hand, countries specializing in the products independent of
external finances will have a less developed financial system. Hence, trade openness
contributes positively to the financial development in the long-run; however, trade-
finance nexus may be negative in the short-run (Kim and Lin, 2010).

According to Rajan and Zingales (2003), different old interest groups may
hinder the process of financial development as an advanced banking system facilitates the
investment prospects of newly established businesses. Moreover, the simultaneous
opening of finance and trade not only weakens the incumbent's capability to oppose
financial sector development but also helps to change the views of opponent interest
groups. Braun and Raddatz (2005) examine a political channel of trade-finance nexus.
They explain that trade openness reduces the supremacy of the interest groups willing to
block financial development or any improvement in the financial intermediation.

II. Openness and Financial Development in Emerging Asia

Economic Globalization and liberalization trends started getting popular in Asia
from the late 1980s. Japan, Malaysia, South Korea, Singapore and China have reaped
substantial benefits from the global investment flows, knowledge sharing, and rapid
economic growth. The per capita incomes in most of the Asian economies grew and the
poor received higher wages after obtaining export quality manufacturing jobs. The Asian
financial crisis proved to be a blessing in disguise for the institutional and banking system
reforms. These financial reforms consisted of improved monetary policy management,
fiscal consolidation, bank supervision and other financial system regulations.

1
The concept presented by McKinnon (1973) and Shaw (1973) pointing out towards government regulations
and interest rate ceilings.
 1633
East Asia outperformed the other regions of the world in terms of economic
growth over the last two decades. The ASEAN countries went through major
improvements in their financial systems since the 1990s. The stock markets and other
financial institutions witnessed remarkable development after the financial catastrophe.
However, the role of financial markets still seems to be very limited as compared to the
banks. A small number of companies control the issuance of a major proportion of equity
while many secondary markets stand shallow and illiquid. The public sector accounts a
lion's share in the bond markets and the overall financial system still needs to be
developed properly. In general diverse levels of financial development can be witnessed
in Asia and Pacific region. Even advanced economies of the region show very different
scores on financial development indicators. According to the financial development
report by the world economic forum 2012, China and Hong Kong stood better in terms of
business environment and banking system efficiency but the performance in terms of
overall macroeconomic indicators and public debt management remained relatively poor
in these countries.

Thailand and Korea republic performed well in terms of financial access but
financial stability and institutional environment indicators remained incompetent. Asia is
the home to nearly 40% of the world's poor. Broadening financial access through
financial sector development can play a substantial role in alleviating poverty in the
region. A developed and efficient financial system allocates capital to more profitable
investment ventures and promotes innovations which are pivotal for economic growth.
The emerging Asian economies especially China and India are the major players in the
developing world. The South Asian countries especially India, Pakistan and Bangladesh
also started to liberalize their economies in the 1990s. Emerging Asia has become a
major driver of economic growth in the global economy enhancing its share in the world
output rapidly. The focus on the development of financial system by identifying
important determinants of banking system development are the issues of great concern
for the policy makers of emerging Asian economies.

The modern trait of openness demands a developed banking sector to manage

the external finances properly. So, in the presence of openness, financial sector is
compelled to enhance its efficiency to evade any type of financial crunch. A major
motivation of this study is to examine the influence of openness on financial sector
development in the Asian emerging markets because macroeconomic volatility of foreign
flows can only be avoided through sophisticated financial intermediation.

III. Literature Review

Baltagi, Demetriades and Law (2005) used GMM technique to examine the role
of openness to promote financial sector development. The empirical results demonstrated
that financial development is positively influenced by trade and financial openness but
the marginal impact of simultaneous openness of trade and finance is negative in the
economies which are already open. Ito (2005) explored the effect of openness on
financial depth after incorporating the institutional development using data on 87
developing economies from Asia during 1980-2000. It was empirically found that
financial openness develops the equity market after attaining a threshold level of
institutional development. Moreover, trade openness was found to be an imperative factor
affecting banking system development in Asia.
1634 Pakistan Journal of Social Sciences Vol. 40, No. 4

Manzie and Ito (2005) evaluated the effect of financial opening on the financial
infrastructure development by using data of 108 economies for the period 1980- 2000.
The empirical results revealed that openness is a major factor to develop the financial
system in the economies at the lower stages of development. Law and Demetriades
(2006) and Baltagi et al. (2009) studied the role of financial and trade openness in
reshaping the financial architecture by applying panel data GMM technique. The
empirical findings depicted that the individually trade and financial openness affect
financial development positively but the marginal impact of simultaneous trade and
capital account openness is negative in the already open economies. Law and
Demetriades (2006) explored the effect of institutions and openness on financial sector
development in developing countries using a data sample of 1980-2001. The empirical
results using GMM indicated that capital account openness, trade openness and
institutions are the vital factors affecting financial development. McDonald and
Schumacher (2007) examined the role of financial openness and institutions in
developing the financial sector of developing economies from Sub Saharan Africa (SSA).
The authors considered 37 economies with a data sample for the period 1983-2004. The
empirical results indicated that capital account openness and institutions are the
significant determinants of financial sector development.

A substantial amount of literature revealed that the interaction between financial

and trade openness may affect financial depth. So Simultaneous openness hypothesis
(SOH) was found to be valid in some empirical studies conducted by Law and
Demetriades (2006), Baltagi et al. (2009), Acikgoz et al. (2012), Zhang et al. (2015), and
Onanuga and Onanuga (2016). However, some empirical studies including Kim et al.
(2010), Le et al. (2016) and Muhammad et al. (2016) found that only financial or trade
openness contributed positively towards financial development. Some empirical studies
yield mixed findings while exploring the SOH while others negate any type of significant
interaction. David et al. (2014) discovered that the role of trade openness is more
important than financial openness to develop the financial sector in SSA region. Le et al.
(2015) explored the relationship between trade openness and financial development by
incorporating the role of institutions for 26 economies of East Asia and Pacific. Dynamic
GMM estimation technique is applied using data for the period 1995-2011. The
empirical results revealed that trade openness and economic growth along with better
institutional quality prosper financial development. Ozkok (2015) examined the linkage
between financial openness and financial sector development after incorporating
educational and institutional variables in the advanced and emerging economies. It was
observed that different indexing strategies perform better in extracting financial openness
and financial development measures as compared to the individual indicators. A
financial openness index constructed by using principal-component analysis exhibits a
positive influence of financial openness on financial development.

Bayar et al. (2017) assessed the impact of openness on financial development by

considering Central and Eastern European economies for the period 1996-2014. The
Westerlund and Edgerton co-integration technique was applied to conclude that openness
positively influence the financial sector development in the long-run. Ashraf (2018) used
data on 287 main banks from 37 EMEs for the period 2000-2012 to explore the positive
contribution of trade openness to the private credit provided by the banks. Aluko et al.
(2019) examined the impact of openness and democracy on the banking sector
development in 33 countries of SSA region. Using data from 1991 to 2015, the
 1635
researchers found a support for the simultaneous openness hypothesis. Asongu et al.
(2020) assessed the simultaneous openness hypothesis in 25 sub-Saharan African
countries for the period 1980-2014. The empirical results using GMM
approach confirmed the validity of simultaneous openness hypothesis in SSA countries.

IV. Empirical Methodology and Data

The econometric specification of this paper aims at investigating the effect of
opening finance and trade on financial sector development in emerging Asian economies
including China, India, Indonesia, Malaysia, Pakistan, Philippines, and Thailand for the
period 1999-2019. Arellano-Bover/Blundell-Bond linear dynamic panel data generalized
method of moments (GMM) system estimation technique is applied. The econometric
specification can be written as given below;

FDit = α1FDit−1 + α2 FOPit + α3 TOPit + α4 {FOPit × TOPit} + α5 GDPPCit + α6 IQit + uit

Where FD is financial development represented by domestic credit to the private

sector (% of GDP). Financial openness (FOP) is measured as FDI and total liabilities
(LIB) in turn. We use FDI and LIB both as a percentage of GDP. Trade openness (TOP)
is measured by two indices including trade in goods and services as a percentage of GDP
(TO) and merchandise trade (MT) both expressed as a percentage of GDP. The real GDP
per capita (GDPPC) and institutional quality (IQ) are also included in the model as
control variables. The notation uit represents a white noise error term.

In our study, only de facto measures of financial and trade openness are used.
This type of measures is practically better than that of de jure measures because of its
ability to reflect the actual extent of openness. The data on all types of proxies for FD,
FOP and TOP alongwith GDPPC are obtained from the World Development Indicators
(WDI). The sum of three sub-indices from International Country Risk Guide (ICRG) is
used to represent IQ. These sub-indices include corruption, law & order and bureaucratic
quality. The GMM estimation technique of dynamic panel data introduced by Arellano-
Bover (1995) and developed by Blundell-Bond (2000) is used for estimation in this study.
GMM methodology helps to eliminate any endogeneity problem arising due to the
correlation between time-invariant country-specific characteristics and the regressors.
The dynamic panel model involving the lag dependent variable as a regressor is better to
control the endogeneity problem (Roodman, 2009). Another advantage of system GMM
is that it can perform better than differenced GMM in multivariate dynamic panels.

V. Hypothesis Testing
For the purpose of testing the simultaneous openness hypothesis, partial
derivatives of FD are obtained with respect to trade or financial openness. These
derivatives can be inferred as the marginal effect of trade or financial openness as given
below;
∂FDit/∂TOPit = α2FOPit

∂FDit/∂FOPit = α3TOPit
1636 Pakistan Journal of Social Sciences Vol. 40, No. 4

According to Baltagi et al. (2009), these marginal impacts are positive for the
relatively closed economies and negative for the countries which have already adopted
openness policies.

VI. Estimation Results

Table 1 presents the estimation results using the Arellano-Bover/Blundell-Bond
GMM system technique with FDI as a proxy for financial openness. The dependent
variable is domestic credit to private sector as a proxy for financial development (FD).
FDI is found be positive and strongly significant at one percent level because it facilitates
the import of modern techniques of production, accumulates domestic savings and
reduces the cost of capital which leads to the domestic financial sector development in
the recipient economy (Prasad, 2003). The system GMM results of in the first and second
specification indicate that a one percent increase in the ratio of FDI to GDP would bring
2.29 to 2.67 percent rise in financial depth respectively. The coefficients of lagged
dependent variable and GDP per capita are found to be positive and significant at one
percent level in both specifications.

Table 1: Dependent Variable: Domestic credit to private sector (% GDP)

System GMM (i) (ii)
FD (-1) 0.8640* 0.8605*
(0.0304) (0.0303)
FDI 2.2906* 2.6742*
(0.7373) (0.7500)
TO 0.0346***
(0.0212)
MT 0.0401***
(0.0237)
FDI*TO -0.0307*
(Interaction term) (0.0063)
FDI*MT -0.0382*
(Interaction term) (0.0073)
GDPPC 0.0026* 0.0026*
(0.0003) (0.0003)
IQ 0.2545 0.2471
(0.4000) (0.3988)
Number of obs. 126 126
Number of groups 7 7
Wald chi2(6) 22036 22063
Prob > chi2 0.000 0.000
Note: The numbers in parentheses are standard errors while * and *** indicate statistical significance at 1% and
10 % levels, respectively

The representation for trade openness is made by using two indicators including
total trade in goods and services as a percentage of GDP (TO) and merchandised trade as
a percentage of GDP (MT). Both measures of trade openness are positive and significant
at 10 percent level because opening of an economy to trade gives vent to international
bank transactions and stimulates the banking sector development. The weaker institutions
in the emerging market economies do not play any role in the financial sector
development that’s why IQ remains statistically insignificant in both specifications. The
interaction term is used to test the simultaneous openness hypothesis. Both interaction
terms (FDI*TO) and (FDI*MT) are found to be negative and statistically significant at
one percent level in both specifications. It implies that financial sector development is
negatively affected by the simultaneous openness of finance and trade in the emerging
 1637
Asian economies because they are already open. The empirical results are similar to
Baltagi (2009), Onanuga & Onanuga (2016) and Aluke et al. (2019).

Table 2 shows the results which are very similar to the previous estimates
provided in table A. The lag of financial development is highly significant at one percent
level with a positive sign. Foreign liabilities as percentage of GDP (LIB) are included in
the regressions to represent financial openness. In both specifications, LIB is statistically
significant at one percent level. The domestic banks in financially open emerging
economies are compelled to enhance their efficiency to manage the influx of funds from
abroad.

The coefficients on trade openness measures including TO and MT are positive

and statistically significant at one percent level. Trade openness leads to international
bank transactions which enhances the banking sector efficiency and stimulates financial
sector development. The institutions in emerging market economies are comparatively
fragile which do not play any significant role in the financial sector development. So, IQ
remains statistically insignificant in both specifications.

The empirical findings reveal that both trade and financial openness stimulate
financial sector development independently. Both interaction terms are again statistically
significant with a negative sign. The negative interaction terms signify the decreasing
marginal impact. In our sample all the Asian EMEs are already open, consequently, the
sign of interaction term is negative in both cases. Our empirical findings are in line with
Baltagi (2009), Acikgoz et al. (2012), and Bayar et al. (2017) partially supporting the
famous Rajan and Zingales hypothesis.

Table 2: Dependent Variable: Domestic credit to private sector (% GDP)

System GMM (i) (ii)
0.8204* 0.8196*
FD (-1)
(0.0385) (0.0379)
0.1745* 0.1713*
LIB
(0.0390) (0.0384)
0.1110*
TO
(0.0417)
0.1179*
MT
(0.0447)
LIB*TO -0.0015*
(Interaction term) (0.0004)
LIB*MT -0.0017*
(Interaction term) (0.0005)
0.0019* 0.0020*
GDPPC
(0.0004) (0.0004)
0.5056 -0.3610
IQ
(0.4154) (0.4069)
Number of obs. 126 126
Number of groups 7 7
Wald chi2(6) 21352 21728
Prob > chi2 0.000 0.000
Note: The numbers in parentheses are standard errors while asterisk (*) indicates statistical significance at 1%
level
1638 Pakistan Journal of Social Sciences Vol. 40, No. 4

VII. Conclusion
The study investigates the effect of openness on financial sector development in
the seven EMEs from Asia. The empirical results are obtained by using advanced
dynamic panel data GMM approach to tackle the endogeneity issue. The empirical
estimates depict the positive and statistically significant influence of financial and trade
openness on financial sector development individually. However, the minus sign of
interaction terms divulges the negative marginal effects of simultaneous openness of
trade and finance.

The negative marginal effects show that relatively closed countries obtain more
benefit from openness than the closed ones. Although the openness of both types may be
more beneficial for the economy, one type of openness without the other is potentially
viable to provide benefits in the form of financial sector development. Hence, the
findings of our study only partially support the Rajan and Zingales hypothesis which
recommends both types of openness to accomplish the financial sector development. Our
empirical results have some important policy implications for emerging economies.

Any aggressive steps towards simultaneous openness of trade and capital

accounts may not promote financial development in case of EMEs as these economies are
already open. So there should be a sequential approach towards opening up of current and
capital accounts. The policy of trade openness should be adopted at the first stage while
financial openness may be considered later as the economy is properly prepared for the
foreign capital flows. Furthermore, emerging economies should focus on the product
specialization and export the goods of their comparative advantage to reap the benefits of
openness and consequent financial development.

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