The effects of financial liberalization on economic growth case study for ASEAN countries by using KAOPEN index

UNIVERSITY of ECONOMICS

ERASMUS UNIVERSITY ROTTERDAM

HO CHI MINH City

INSTITUTE of SOCIAL STUDIES

VIETNAM

The NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

The Effects of Financial Liberalization on
Economic Growth
Case Study for ASEAN Countries By Using of
KAOPEN Index

BY

NGUYEN HUNG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, NOV 2016


UNIVERSITY OF ECONOMICS
HO CHI MINH CITY

ERASMUS UNIVERSITY ROTTERDAM
INSTITUTE OF SOCIAL STUDIES

VIETNAM

THE NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

The Effects of Financial Liberalization on
Economic Growth
Case Study for ASEAN Countries By Using of
KAOPEN Index
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

NGUYEN HUNG

Academic Supervisor:

Professor, Doctor Nguyen Trong Hoai

HO CHI MINH City, November 2016

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DECLARATION
“This is to certify that this thesis entitled “The Effects of Financial Liberalization on
Economics Growth. Case Study for ASEAN Countries by Using of KAOPEN
Index”, which is submitted by me in fulfillment of the requirements for the degree
of Master of Art in Development Economics to the Vietnam – The Netherlands
Programme (VNP). The thesis constitutes only my original work and due
supervision and acknowledgement have been made in the text to all materials used.”
Nguyen Hung

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ACKNOWLEGEMENT
This thesis has been completed with a great deal of supports and encouragements
that I have been receiving from many people. To whom I am indebted.
I owe a debt of gratitude to Professor Nguyen Trong Hoai, my academic super
visor, for his invaluable instructions and guidance during my work. He has been
stimulating my critical thinking skills and guiding me to rethink and to deconstruct
my thesis topic. Hence, his expertise has helped me very much to compile necessary
skills in thinking, writing, and fulfilling this thesis. Moreover, he took time to
diligently review my final thesis draft and help to correct the errors and the wrong
words usages.
Furthermore, I would like to thank Dr. Truong Dang Thuy for his enthusiasm of
keeping me in schedule of thesis writing. I would like also to thank Dr. Pham
Khanh Nam and Dr. Le Van Chon for their helping in developing concept note,
thesis research design, and searching data.
I must show my gratitude toward all lecturers VNP who have broadened my
perspectives and encouraged me to fulfill my knowledge as this program
requirements. Then, I want to say thanks to VNP officers as well as VNP librarian

for their support of good conditions and study materials during the study period.
Next, I wish to express my thank you to all my friends here at VNP. Together we
have walked and struggled through this whole treasured journey of learning and
shared memorable and priceless moments.
Last but not least, I am very deeply grateful to my family that is an indispensable
element to constitute my achievement.

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ABSTRACT
This study aims to verify the association between financial liberalization and
economic growth in ASEAN countries, by using the annual panel data set from
1990 to 2013 at the country level. The regression model is base on the form of
growth model and similarly with Bekaert et al. (2005) model, in which the ChinnIto index (KAOPEN) serves as proxy for financial liberalization. (KAOPEN) is
frequently used in recent researches, since it is updated annually, available in
Internet, and cover about 180 countries in the world. The Fixed effect model (FEM)
and random effect model (REM) techniques are used to estimate the effect of
financial liberalization on economic growth. The result of the regression provides
the evidence that financial liberalization have positive effects on economic growth
in ASEAN countries, including Viet Nam. However, the significant level is not
strong in (REM) model, but strong significant in (FEM). This result is also
illustrated by the recently integration process of ASEAN. The experiment of
ASEAN shows that as one form of financial liberalization, FDI have not only
brought foreign capital inflows but also the collateral benefit to the host countries.

Key Words: Financial Liberalization, economic growth, ASEAN, relationship,
association, total factor of production (TFP), Foreign Direct Investment (FDI).

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ABBREVIATION
AEC
ASEAN Economic Community
APEC
The Asia-Pacific Economic Cooperation
AREAER Annual Report on Exchange Arrangement and Exchange Restrictions
ASEAN
the Association of Southeast Asian Nations
EU
European Union
FEM
Fixed Effect Model
IMF
International Monetary Fund
GDP
Gross Domestic Product
GNP
Gross National Product
OECD
the Organization for Economic Co-operation and Development
REM
Random Effect Model
WTO
the World Trade Organization

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TABLE OF CONTENTS

TABLE OF CONTENTS …………………………………………………………………………………………………
LIST OF TABLES ................................................................................................................
LIST OF FIGURES ..............................................................................................................
CHAPTER 1: INTRODUCTION ...........................................................................................
1.1 Problem statements ..................................................................................................
1.2 Research objectives ...................................................................................................
1.3Research questions: ...................................................................................................
1.4 The scope of study .....................................................................................................
1.5 Research structure ....................................................................................................
CHAPTER 2: LTERATURE REVIEW .....................................................................................
2.1 .Theoretical literature ................................................................................................
2.1.1. Economic Growth and Growth Theory:...................................................................
2.1.2. Financial Development ..........................................................................................
2.1.2.1. Financial Deepening .........................................................................................
2.1.2.2. Financial Repression…………………………………………………………………………………………
2.1.2.3. Financial Liberalization ……………………………………………………………………………………
2.1.2.4. Financial Liberalization and Economic Growth…………………………………………………
2.2. Empirical Studies……………………………………………………………………………………………………
2.3. Chapter Remarks ………………………………………………………………………………………………….
CHAPTER 3: RESEARCH METHODOLOGY .........................................................................
3.1. Model Specification ..................................................................................................
3.2. Measuring Financial liberalization ...........................................................................
3.2.1. The IMF’s AREAER .................................................................................................
3.2.2. Quinn’s Measure ..................................................................................................
3.2.3. KAOPEN Measure ..................................................................................................
3.2.4. KA Measure ……………………………………………………………………………………………………….
3.2.5. SHARE Measure ………………………………………………………………………………………………..
3.3. Endogenous Problem from the relationship between Financial Liberalization and

Economic Growth ……………………………………………………………………………………………………..
3.3.1. Instrumental Variables ……………………………………………………………………………………..
3.4. Measurement of Variables …………………………………………………………………………………..
3.4.1. Dependent variable ………………………………………………………………………………………….
3.4.2. Independent Variables ……………………………………………………………………………………….
3.4.2.1. KAOPEN indicator (kaopen1) …………………………………………………………………………
3.4.2.2. Log Initial GDP (lgdp90) ………………………………………………………………………………….
3.4.2.3. Government consumption / GDP (gconsume) ………………………………………………..
3.4.2.4. Secondary school enrollment (second) ………………………………………………………….
3.4.2.5. Population growth (pop) ………………………………………………………………………………..
3.4.2.6. Log life expectancy (llife) ……………………………………………………………………………….

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3.4.2.7. Dummy Variables: (dlegal) ………………………………………………………………………………
3.5. Data collection …………………………………………………………………………………………………….
3.6. Model Specification …………………………………………………………………………………………….
3.7. Chapter Remarks …………………………………………………………………………………………………

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CHAPTER 4: RESEARCH RESULTS ....................................................................................
4.1 Overview Economic Growth and Financial Liberalization in ASEAN…………………………
4.1.1. Overview the economic growth in ASEAN in the period 1990 – 2013………………….
4.1.2. Foreign Direct Investment (FDI) Inflows into ASEAN……………………………………………
4.1.3. ASEAN Banking Sector…………………………………………………………………………………………
4.1.4. Capital account openness in ASEAN countries. ………………………………………………….
4.2 Descriptive Statistics. …………………………………………………………………………………………….
4.3. Model Estimation Result. …………………………………………………………………………………….
4.3.1. Result of Test for Panel Data Model. ………………………………………………………………….
4.3.2. Discussion on the Research Result. ……………………………………………………………………

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CHAPTER 5: CONCLUSION AND RECOMMENDATION .....................................................
5.1. Conclusions. ............................................................................................................
5.2 Policy implications. ....................................................................................................

5.3. Research limitations. ..............................................................................................
5.4. Suggestions for Further Research. ..........................................................................
………………………………………………………...............................................................................
REFERENCES ....................................................................................................................
APPENDIX A: PANEL REGRESSION MODEL ......................................................................
APPENDIX B: RESULTS OF HAUSMAN TEST ......................................................................

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LIST OF TABLES
Table 2.1: The role of financial Liberalization in economic growth ……….. 24
Table 3.1: The expected sign of variables in model ………………………...

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Table 4.1: Summary statistics of Variables used in the regressions ………..

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Table 4.2: The Correlation on the sample observations …………………….

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Table 4.3: The results of Hausman Test …………………………………….

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Table 4.4: The Result of Regression

……………………………………… 66
End.

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LIST OF FIGURES
Figure 4.1: The average of real GDP growth ……………………………………

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Figure 4.2: Emerging Asia - FDI inflow, 2000-2013 ……………………………

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Figure 4.3: FDI in ASEAN-4, Singapore and Viet Nam (value in US$ million) ..

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Figure 4.4: FDI in VIETNAM …………………………………………………… 50

Figure 4.5 Domestic credit to private sector by banks (% of GDP)………………. 52
Figure 4.6 Financial liberalization in ASEAN-4, Singapore and Viet Nam ……...

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Figure 4.7 Financial liberalization in some Asia countries and Viet Nam………... 55
Figure 4.8: The scatter diagram for economic growth rate and financial
Liberalization…………………………………………………………. 58
Figure 4.9: The scatter diagram among dependent variable and financial
liberalization variable for each ASEAN country …………………….. 59
Figure 4.10: The scatter diagram among dependent variable and control variables

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End.

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CHAPTER 1: INTRODUCTION
1.1 Problem Statement
Recent years have emerged the concern in the issue about globalization, which
included international economic integration and financial globalization in across
countries, has scholarly instigated by many descriptions and analyses of researchers.
According to Mckinnon (1973) and Shaw (1973), asserted that the important roles
of financial are essential for technological innovation and economic development.
As strong evidences in most research, there is without doubt in this saying.
However, the study of financial liberalization growth nexus has received opposite
opinions, while the tendency toward the world economic integration requires local
market openness including financial market, and some adjustments in financial
rules, thus providing the going debate about whether positive or negative effect of

financial liberalization on economic growth.
According to Sachs and Warner (1995), Rodrik (2000) technology and economic
institutions have rapidly developed to reach the achievement of advance, the
distances between countries become narrower. This will encourages more
international trade and investment to reduce costs for both consumers and
producers, and this stronger requirement to expend trade will in turn enhance the
process of international economic integration. The common example for
international economic integration is the World Trade Organization (WTO), which
was established by agreement of more than 120 economies. Similarly, the
International Monetary Fund (IMF) now involves nearly universal membership,
with member countries promise to comply with the basic principles of currency
convertibility. Recently, going along with the large GDP and the high value of
international trade, China’s currency which named Chinese renminbi (RMB) have
met the criteria for Special Drawing Right (SDR) basket as the decided of IMF’s
Executive board in November 2015, and RMB will become the convertible
currency. On October 1, 2016 RMB would join the SDR basket, together with the
four other global currencies of trade. In the SDR basket will be including U.S.

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dollar: 41.73 percent, Euro: 30.93 percent, Chinese renminbi;10.92 percent,
Japanese yen: 8.33 percent, Pound sterling: 8.09 percent respectively. The first
advantage of freely convertible RMB is that it is very inexpensive to buy and sell,
so that could be reduce the spread cost (the different price in buy and sell) of bank.
At smaller scale, there are varying levels of economic integration, including
preferential between member countries, the integration between countries in the
same continent, region such as in the Europe have established the Organization for
Economic Co-operation and Development (OECD), European Union (EU), and the
development of this is Euro zone. In the Asia there are the institutions that can be

counted as The Asia-Pacific Economic Cooperation (APEC), the Association of
Southeast Asian Nations (ASEAN). The new one, ASEAN Economic Community
(AEC) has established in the December 2015, that including Viet Nam and other
ASEAN member countries. (AEC) is the pledged of member countries to realize the
principles of an Economic Community which bases on the idea of the European
Union’s model. The foundation of AEC is based on the four basic elements which
are named as: single market and production base, competitive economic region,
equitable economic development, ASEAN’s integration into the globalized
economic. The aim of this is to turn ASEAN market into the unified market in
which free of producing products, free trade of goods and service everywhere in the
region of ASEAN. It also gives prominence to the competition in production and
export activities over the region and within a country. To ensuring the development
equity, requiring people and firms should be engaged into the process of AEC. The
last element emphasizes the need that ASEAN must integrate into as a part of the
world economic. This is the advantage, because of the good position of ASEAN in
the middle of global supply chain, trade could be developed connect with other
major economics in the world and could be lead to more new business
opportunities. From the above element, AEC gives the core principles of the
ASEAN single market and production base are free flow of goods, services,
investment, capital, and skilled labor. As demand in promoting trade, ASEAN has

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obtained its target in the trade duties reduction. Brunei Darussalam, Indonesia,
Malaysia, Philippines, Singapore have reduced tariff to 0 %, Cambodia, Lao PDR,
Myanmar and Viet Nam also reduce tariff to 0-5%. Moreover, to encouraging
investment, the investment environment has built in a principle that ensuring the
liberalization and protection investment of cross border countries. In which, apply
the best practices for treatment of foreign investors and investment. In addition,

implementing the free flow of capital, stock exchanges from member are working
together to first step establishing the ASEAN Exchanges. This is the aim of
promoting ASEAN capital markets and creating more investment opportunities in
the region.
However, the process of integration requires Viet Nam and many other countries
opening the local markets, including domestic financial markets. Nowadays, the
government polices that focus on controlling markets are received many criticized,
for it is likely to be a harm in the efficient functioning and development of financial
institutions. A saying from the writings of professor McKinnon (1973) asserts that
imperfect capital markets play an important role in hindering the growth of
developing countries, since the fragmentation of the economies in both institutions
and policy measures. This shortcoming discourages the effective mobilization and
reallocation of resources. As ASEAN including Viet Nam possess a region that has
more nature resources and advantage in the route of global supply chain, but up to
now the region have not developed as expected, so that it is has an incentive to
study about the effect of financial liberalization and economic growth in ASEAN
countries. Recently, financial liberalization becomes one of the most concerns in
Scholars and policy makers. In the main stream of literature, the positive correlation
between financial liberalization in economic growth has been presented in number
of studies such as Quinn (1997), Klein & Olivei (1999), Quinn & Toyoda (2007),
Chinn & Ito (2005), Bekaert et al. (2005), Henry (2007), Kose et al. (2010), among
others. On the other hand, the other research have not supported for the hypothesis

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that liberalization spur growth, that are the studies of Rodrik (1998), Kraay (1998),
Stiglitz (2000) and may be many other one.
For this reason, this study is conducted to analyze the relationship between financial
liberalization and economic growth in ASEAN countries, based on the model of

Bekaert et al. (2005) in analyzing methodology. However, there are some
differences from Bekaert et al. (2005). Firstly, KAOPEN index is proxy for
financial liberalization variable. Secondly, the data is new, covering the period
1990-2013. Thirdly, the covered countries are focusing in same region, the ASEAN
countries. ASEAN is chosen because Viet Nam is one of member countries of AEC,
hence the consequence of AEC will influence to the Viet Nam Economy. Moreover,
among many studies of financial liberalization focus on a large cross section
countries and region, it likely to be a few studies that focus on this region. Because
many scholars agree that financial liberalization can put the pressures to reform on
the local financial market, through this to strengthening the financial system.
Implementing the article of (AEC), Viet Nam will have some changes in financial
policy measures. This leads to a more concern about the benefit and unexpected
effects of financial liberalization on the economic growth. These are also the reason
for this study is conducted, which intends to find out whether financial
liberalization prompt economic growth in ASEAN in the period 1990- 2013. The
expectation of this study is finding the positive evidence between financial
liberalization and economic growth, for it promoting the integration process.

1.2 Research objectives
-To assess the impact of financial liberalization on economic growth in ASEAN
countries.
-To give some policy recommendation for ASEAN countries related to financial
liberalization and economic growth.
1.3 Research Question

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This study tends to find out the impact of financial liberalization on economic
growth, by applying the quantitative research to a panel data of the countries of

Southeast Asia. This study aims to address two main questions:
-

Does financial liberalization prompt economic growth in ASEAN
countries in the period 1990 – 2013?

-

How does financial liberalization affect economic growth of cross
countries?

1.4 The scope of the study
The research just focuses on small group of countries, the ASEAN member
countries, where have established an Economic Community (AEC) a short time
ago. As demand for opening financial market is the one of the five core principles
of the ASEAN single market and production base in member countries, the
financial liberalization process is expected to be implemented in the ASEAN
countries; including Viet Nam. The ASEAN is chosen in the sample because the
lack of financial liberalization studies focus on ASEAN countries. In addition,
because Viet Nam is one member of AEC, the need is clarifying the correlation of
financial liberalization and economic growth between cross member countries of
AEC.
1.5 The structure of the study
This paper contains 5 main chapters. Following this first chapter of introduction,
chapter 2 presents the critical literature review on economic growth, financial
development, financial liberalization and the effects of financial liberalization on
economic growth. Next, regression model and research methodology are exhibited
in chapter 3, specifies the empirical model to examine the effect of financial
liberalization on economic growth. Chapter 4 gives a brief overview of economic
growth and financial liberalization in ASEAN countries. Then, the descriptive

statistics of the sample, the analyzing, discussing and the result of the study is
presented in this chapter. Finally, chapter 5 concludes the main findings, limitations
and further researches.

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CHAPTER 2: LITERATURE REVIEW:
This chapter introduces three main parts. The first section provides definitions of
financial liberalization and reviews theoretical backgrounds about the role of
financial liberalization in economic growth. The second section summarizes
previous empirical researches. Based on relevant contents, the third section will
depict the construction of conceptual framework for this study.
2.1. Theoretical Literature
2.1.1 Economic Growth and Growth Theory:
Economic Growth
Economic growth is the positive change in producing goods and services of a
country in a period time which compare to another period of time. Economic
growth can be normally measured by Gross Domestic Product (GDP) and Gross
National Product (GNP). In terms of nominal terms, nominal GDP is counted
including inflation. In term of real terms, which called real GDP, is corrected for
inflation. This means that the effects of inflation are eliminated. To compare the
economic growth of one country to another country, GDP or GNP per capita is used
when the population differences between countries are considered. The growth of
an economy could be seen as an improvement in the quality of life. This is not only
as an increase in productive capacity but also as an enhancement the quality of life
to the people of that economy. To depict the issue of economic growth, basing on
the neoclassical, the exogenous growth theory, endogenous growth theory are
developed.

Neoclassical growth theory
According to Barro (1991), Howitt (1999), in neoclassical growth theory, economic
growth is generally related with technological changes. Solow-Swan growth model
(exogenous growth) reflects the relationship of output and capital, labor, and
technology. Economic growth will exert if there is an increase in capital relative to
labor until the economy obtains the steady state. At the steady state, despite an

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increase in capital and labor, economic growth will be unchanged. At that time the
technology change plays the key role for the economy to overcome that steady state.
Endogenous growth theory
Base on the foundations of neoclassical, endogenous growth theory has been
developed to explain the long run economic growth as arising from economic
activities that are the process to create new technological knowledge. As this
concept draws the outline of theory, especially the “Schumpeterian” vision variety
in innovation. Endogenous growth theory depicts that endogenous growth is long
run growth at a rate determined by one or more by factors generated in the
economic system instead of outside factors, particularly the factors that dominate
the opportunities and incentives to create technological knowledge. Because of this,
it can draw the model with one or more these elements such as AK model, in which
the engine for growth can be simple a constant return to scale production function.
This is the first version of endogenous growth theory established from the
production function:
Y = AKα (HL)1-α

A is standing for the production technology. When put H = K/L is human capital,
there is a new production function Y = AK. Dividing two sides of equation by L, it
give y= Ak. This proves that the marginal productivity of capital A does not reduce

when the capital stock increases. This model still assumes constant return to scale,
but it does not explicit the diminishing return to scale. The AK theory assumes
capital as important element that directly contributes to the production. This also
increases human capital, then rising linearity output with the capital stock. AK
theory points out that an economy’s long run grow rate depends on its saving rate.
This means that a higher saving rate will conduct to a higher growth rate, and higher
population growth rates will lead to lower income per capita.

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Aghion and Howitt (1998) think that there are some different between neoclassical
model and endogenous growth theory that in endogenous growth theory the growth
per capital can continue without basing on exogenous technology changes, and
there is no convergence of income, so that the poor countries will not necessarily
growth faster than rich countries. However, like with Solow model, the key role of
accumulation of production factors and the increasing in productivity in the
growing process are also emphasized in endogenous growth theory.
In this study both of theories are employed to explain the correlation of the
variables in regression model, the factor effecting growth in the economy. For
example, the convergence of income could be interpreted by neoclassical theory,
and the total factor productivity increasing is explained by AK model,
2.1.2. Financial Development
Financial development is defined as an improvement in the quality, quantity and the
efficiency of financial system. This process involves the combination of many
activities and institutions.
Beck et al. (2000) agree with Schumpeterian view of finance and development: that
higher level of financial development spur economic growth by affecting total
factor productivity growth. According to Levine (2005), financial development
happens when financial instruments, markets and intermediaries are improved

better, then they affect the information, enforcement and transaction costs.
In the literature financial development spur growth by the well functioning financial
system that could be briefly presented through two channels: increase in financial
deepening that raise investment, and efficient resource allocation which enhance the
productivity growth up
Financial deepening is defined as the increasing the ratio of financial assets to GDP
that means increasing providing financial services to all levels of a society. This
could encourage saving, more capital accumulating, for that investors could find the
other capital sources to finance for their projects. It means improving investment.

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In addition, financial development plays an important role in raising productivity
growth. As saving rates increasing, savers could invest in the financial system and
gain profits. When they do so, capital runs into the financial markets, financial
intermediaries where are willingly to screening, selecting and monitoring potential
users of capital. After that, the good projects will be finance by the outside capital
and the unproductive ventures fail to be financed. This point out that financial
markets and financial intermediaries contribute to distribute resources efficiently.
At the end of this process, productivity is increasing in the whole economy.
Measurement of financial development
According to Beck et al. (2000) financial development could be measured by the
size, the activity, and the efficiency of the financial sector.
To measure the size of financial sector, the “liquid liabilities ratio” indicator is used.
This is formed by the currency plus demand and interest bearing liabilities financial
intermediaries and non-bank financial intermediaries divided by GDP (Beck et al.,
2000); (Goldsmith, 1969); (McKinnon, 1973). This indicator could also be used as
proxy for financial deepening since it covers all types of financial institutions.
The activity of financial sector could be measure by the role of commercial bank

compared with central bank or the importance of bank in the allocation of society’s
savings. “Commercial- Central bank assets” indicator which formed by the ratio of
asset of deposit money banks divided by the sum of assets of deposit money banks
and central bank assets.
The “ratio of credit to the private sector” is another indicator measuring the activity
of financial sector as well as the common measure of the efficiency of resource
allocation in the financial sector. This indicator is more advantageous than the
measures of monetary aggregates because it clarifies the real amount of funds
finance to the private sector. When the ratio of domestic credit as a percentage of
GDP is higher, the economy has higher domestic investment and higher level of
financial system development. Domestic credit to private sector can be used as a
proxy for the private credit (De Gregorio & Guidotti, 1995).

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2.1.2.1 Financial Deepening
Financial deepening is defined as the increasing the ratio of financial assets to GDP
that means increasing providing financial services to all levels of a society. This is
measured by formula:
𝑀2

K = 𝐺𝐷𝑃
Where M2 is measure of the money supply which including cash, checking, and
saving account.
It may also be calculated by the ratio as below

K=

𝐶𝑟𝑒𝑑𝑖𝑡

𝐺𝐷𝑃

Financial deepening generally used to present the meaning of increasing ratio of
money supply to GDP, thus expressing the liquid money. In the tradition meaning,
higher liquid money leads to more investment, more opportunities and then higher
economic growth. As financial services are available to individual and households,
the basic services such as health, education become easily to be accessed by
common people, thus providing an important boost to poverty reduction.
According to King and Levine (1993) financial deepening is one of four indicators
to measure financial development of a country. In their study, among many other
studies, financial deepening has a significant positive effect on economic growth.
2.1.2.2. Financial Repression:
The government policies that focused on restricting and controlling financial
markets have been known in literature as financial repression. Many governments

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feel themselves the need to impose many type of restrictions which are classified
into four categories by the IMF’s Annual Report on Exchange Arrangement and
Exchange Restrictions (AREAER)
Since the early 1970s, many scholars have long been concerned that numerous
government policies which focused on controlling financial market, for it was felt
that these policies are generally taken to be a bad thing normatively that impeded
the efficient functioning, development of financial institution and distorted the
domestic financial market. According to Mckinnon (1973) and Shaw (1973), both
authors showed their view of point as a critique of government restrict policies in
financial market. Many governments feel themselves the need to intervene in the
sphere of finance to mobilize and support for the activities that they expect to
develop domestic economy. The government restrict policies in financial market

may be come from some reasons such as the government’s fear of dependence on
foreign capitalism, the need to aid state own firms or preventing domestic saver
seeking higher return in international market.
Quinn and Toyoda (2007) suggest that through the 1980s many developing
countries clearly refuse the model of financial openness proposed by developed
countries because the fear of dependency interpretation of modern capitalism. If a
country were to accept the export of foreign capital, it sets itself up for, at best,
economic colonialism. Some countries, hence, forbid international capital. This
standpoint shows that developing countries should better keep isolate form rich
countries who exploit poor countries was central to developed country wealth and
developing country poverty. In the development point of view, developing nations
should undertake import substitution industrialization which advocates replacing
foreign imports with domestic production in order to improve their terms of trade,
which requires partial financial closure.
2.1.2.3. Financial Liberalization:

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Financial liberalization is a very broad term that usually has the meaning that fewer
government regulations and restrictions in the financial market. In other words,
liberalization refers to deregulation or removing of controls. Following Kunt and
Levine (1996), deregulation of interest rate and more loosened entry policies in
exchange for greater private entities, often conducted to significant financial
development. Specially, in the developing countries where there was considerable
repression of government policy in the economy management. Nevertheless, the
fervor of which financial liberalization was implemented in some countries in the
lack of or low performing of lending institutions and instrument, improve more
reforms. Over the past two decades, many developing countries have reformed their
domestic financial markets, due to the requirement of domestic and international

developments. The short define is that financial liberalization refers more to
liberalization or further "opening up" of their own economies to foreign capital and
investments, or the simple way: when a country allows money to move in and out of
a country freely.
Bumann et al. (2013) suggest that in the literature, financial liberalization can raise
the efficiency of financial market that help to transform saving into investment.
Edison et al. (2004) summarize that financial liberalization enhances the efficiency
in resource allocation, makes risk diversification more easily available to the firms
and investors, speeds up process of financial development, hence improving the
economic growth.
To measure the degree of financial liberalization of a country, Bumann et al. (2013),
Quinn et al. (2011), Cline (2010) state that up to now, various indicators are
developed to measure capital account openness applying for most of countries in the
world. All of indicators can be discriminated in to 3 groups that are called: de jure,
de facto, and the hybrid indicators. The hybrid indicators are the mix between de
jure and de facto. Most of these measures are created base on information from the
Annual Report on Exchange Arrangement and Exchange Restrictions (AREAER)
of the International Monetary Fund (IMF). There are some of indicators that are

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developed to assess the degree of financial liberalization such as: “Share” computed
directly from (AREAER), “CAPITAL” by (Quinn, 1997), “KAOPEN” by (Chinn &
Ito, 2007), “KA” by (Schindler’s, 2009).
In this study, “KAOPEN” indicator is chosen to proxy for financial openness,
because it covers a period time from 1970 to 2013 and is available in internet.
While Quinn’s CAPITAL data stop at the year 2004, too old to use. Usually in the
regression estimation, Quinn’s CAPITAL indicator gives the result more significant
than KAOPEN indicator. However, it is not updated in recent years, so that it is not

chosen. KA has no data for Lao PDR and Cambodia, and it just cover from 1995 to
2013. Because of this, it could not be used in this study.
2.1.2.4. Financial Liberalization and Economic Growth
The mainstream point of view
In general, many scholars have agreed with the perspective that financial
liberalization

spurs

economic

growth

through

several

channels:

firstly,

strengthening local financial market, so that leads more efficient in allocation of
resources, more foreign investment, more saving rate, providing opportunities for
risk diversification. Secondly, help to develop financial systems. Thirdly, picking
up the volume of trade and service, and hence ramp up the competitive abilities of
local country.
Recent years, a great number of descriptions and analyses have been conducted to
clarify the relationship between financial liberalization and economic growth. In the
literature, as the mainstream point of view is that financial liberalization has the
positive relationship with economic growth. The first time mentioning of

liberalization is presented by McKinnon (1973) and Shaw (1973). Both authors
critically focus on financial repression, for it was known as restricting and
controlling in financial markets. This presented by the intervention of government
such as enforcement the interest rate ceilings, directed credit and subsidies to banks.
McKinnon (1973) argue that the weakness of the economics due to both institutions
and policy measures lead to reduce the effective of mobilization and reallocation of

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resource. Relying on an outside money model he point out that a firm faces
financing constraints if using only internal finance. Because of this, both authors
advocate for perfect competition market
Financial liberalization could foster a more strengthening local financial market, so
that leads more efficient in allocation of resources, more foreign investment, more
saving rate, providing opportunities for risk diversification. According to Buman et
al. (2013), the neoclassical perspective which assumes that markets are efficient in
allocating scare resource, is the source of most of concept in liberalization. This
perspective has been raised to advocate the positive relationship between financial
liberalization of both credit (i.e. banking) and capital markets lead to economic
growth. In the light of this concept, as introducing market principles and
competition in banking markets will encourage growth in interest on deposits, and
this higher interest conducts to more savings and then more investment. Mckinnon
(1973), Buman et al. (2013) believed that financial liberalization enables to
implement market principle and banking competition, this would increase real
interest rates on deposits which provide an important boost to saving rates. The
savers who are encouraged by the higher interest rate tend to save more money. The
higher saving rates, in turn, providing more amount of resources available to
investment funds. In addition, when financial liberalization opens up the capital
account, capital inflows contribute into capital stock. Financial liberalization

providing opportunity to risk diversification, Bekaert et al. (2005) figured out that
improving risk diversification could reduce the cost of equity capital and increase
investment. Because more foreign capitals are available after financial
liberalization, external finance more easily approach, directly decreases financial
constraints on firms, so it lead to more investments. Moreover, diversification could
help to avoid the full effects of domestic shock as Quinn (1997) suggested.
Financial liberalization and financial development have a causality correlation.
Chinn and Ito (2005) pointed that financial liberalization can lead to development of
financial systems through these channels such as: lessening financial repression to

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protect financial markets that ensuring real interest rate to rise in its competitive
market equilibrium. Moreover, providing more portfolio diversification could
reduce cost of equity capital by reduction in the expected returns to compensate
risks. In addition, financial liberalization strengthens on financial infrastructure by
putting greater pressure for reforming financial system and eliminating inefficient
financial institutions. In other studies, Klein and Olivei (1999) give the evidence
that financial liberalization leads to financial deepening.
Financial liberalization could lead to increase more international trade and more
integration in world market. Removing restrictions on capital account and current
account conduct to more easily in payment that help to more trade transaction. This
will enhance to increase the volume of trade and services between the nation and
foreign countries. Because of this, the local market is more connected with the
world market. In the manufacturing sector, the domestic factor of production could
be paid with the relative price at approximate world price (Hekman & Sweeney,
1997); (Quinn, 1997), so that reduces the cost of production and increases the
countries competitive abilities.
Financial liberalization could raise total factor productivity (TFP) is the suggestion

of recently research. Beck et al. (2000) agree with Schumpeterian view of finance
and development: that higher level of financial development spur economic growth
by affecting total factor productivity growth. This point of view obtain the
supported from Levine (2001), Bonfiglioli (2008), Henry (2007), Bekaert et al.,
(2010) among others. Henry (2007), emphasize that financial liberalization can
enhance the rise in total factor productivity (TFP). The update hypothesis
emphasizes that there are something go along with financial liberalization, which
could give the benefit for the country, the potential collateral benefit. It could
enhance the raise of total factor productivity by strengthening institution,
knowledge spillover in FDI. Moreover, providing opportunities for risk
diversification, that could help firms able to invest in higher growth technology
projects, thus providing an important boost to TFP.

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