Sequencing Financial Reforms: Theory and Evidence

Gonalo Pina
+
Universitat Pompeu Fabra
December 2011
VERY PRELIMINARY
Abstract
In the last 20 years there has been an unprecedented wave of nancial reform.
Financial reform is a complex phenomenon. Dierent reforms have specic timings
and targets, and yield dierent outcomes. In this paper, I investigate theoretically
and empirically the sequencing of dierent nancial reforms.
Using data on nancial reforms for 91 countries between 1973-2005, I study
micro nancial reforms (reforms that target competition in nancial markets) and
macro nancial reforms (reforms that target aggregate prices and quantities). I nd
that macro reforms tend to lead micro reforms. This new stylized fact is puzzling
because this sequencing is associated with lower growth when compared to other
sequencing strategies.
To understand these two observations, I setup a model that explores a second
best view of nancial reform. I show conditions under which performing macro
nancial reforms but not micro nancial reforms is constrained Pareto optimal.
The rst best is not attainable due to the interaction between strategic enforcement
breakdown and three externalities: (i) overborrowing by domestic entrepreneurs, (ii)
lack of coordination between savers, (iii) underinsurance by domestic intermediaries.
An imperfectly competitive nancial sector can internalize some of these externali-
ties. The mechanisms explored in the model are important to explain the dierent
experiences in the sequencing of nancial reforms observed in the data. They can
also account for the negative growth eect of having macro nancial reforms lead
micro reforms.
JEL classication: F33, F34, O16
Keywords: nancial liberalization, competition, capital ows.

I am grateful to Jaume Ventura for his valuable guidance. I thank Fernando Broner, and participants
of the CREI International Lunch and the XII Conference on International Economics for helpful com-
ments and suggestions. I would also like to thank the Fundao para a Cincia e a Tecnologia, from the
Portuguese Ministry of Science and the European Research Council for nancial support. Address: Fac-
ulty of Economics and Business, Universitat Pompeu Fabra, Ramon Trias Fargas 25-27, 08005 Barcelona,
Spain. E-mail: goncalo.pina@upf.edu.
1
1 Introduction
The last forty years have seen a wave of nancial reform unprecedented in its intensity and
scope. Figure 1 plots the sample mean of a nancial reform index for dierent groups of
countries and dierent types of reforms. The solid black line measures average nancial
reform across dierent dimensions. According to this index, nancial reform occurred
earlier and more intensively in advanced economies. But the wave of nancial reform in
the early 90s in developing economies remains one of the most important economic events
in recent times.
In this paper, I study theoretically and empirically the sequencing of dierent nancial
reforms. Financial reform is a multifaceted phenomenon. I divide reforms into macro and
micro dimensions. Macro nancial reforms target aggregate prices and quantities in -
nancial markets. Examples include the lifting of capital account restrictions, or abolishing
interest rate and credit controls. Micro nancial reforms target the structure and organi-
zation of nancial markets. Examples include allowing free entry in the nancial sector,
privatization of nancial institutions, regulation and the promotion of equity markets.
Using data for 91 countries between 1973 and 2005, I nd that macro reforms tend to
lead micro reforms. This particular sequencing of nancial reforms is important because
it comes associated with lower growth. Countries performing alternative sequencing - rst
micro reforms or both macro and micro reforms simultaneously - tend to grow more. This
is a puzzling feature of recent nancial liberalization.
1
To understand these two patterns I setup a simple model of nancial trade, where I
exploit a second best view of nancial liberalization. I focus on two policy dimensions:
capital ow controls (as a macro reform) and domestic nancial competition (as a micro
reform).
2
I take the view that the rst best can only be obtained by lifting all restrictions
to capital ows and competition. But the interaction between strategic enforcement of
nancial contracts and the presence of externalities can make the rst best unattainable.
I show that a simple second best argument justies the sequencing I document in the
data. A less competitive nancial sector has its incentives aligned with enforcement and
partially corrects the externalities. This is the case the smaller are domestic savings, and
the larger are the nancial intermediation needs prior to liberalization. I then perform two
empirical tests of the model. I show that important variables that determine sequencing
strategies in the model can help predict reforms in the data, and that these variables can
account for the negative growth eect of performing rst macro nancial reforms.
The rst contribution of this paper is to document two patterns associated with the
sequencing of nancial reforms in the data. Macro reforms tend to lead micro reforms and
this is associated with lower growth. Figure 1 divides reforms between macro reforms and
micro reforms. Table 1 collects information on the sequencing of reforms in the data.
3
The
evidence suggests that most countries perform macro nancial reforms before engaging in
1
The distinction between macro reforms and micro reforms follows Bandiera et al 2000. Bandiera et
al 2000 study the eect of dierent reforms on domestic savings for a small group of countries. In this
paper, I use the extended dataset by Abiad et al 2010 and investigate the eect of reforms on growth.
2
In particular, the government can open the domestic economy to unrestricted capital ows and can
decide if domestic nancial markets are organized in a monopoly or in perfect competition. In section
2.3. I discuss other examples of micro and macro reforms.
3
Table 1 denes a liberalization as a jump of 0.1 on an index going from 0 to 1. A reform is considered
simultaneous Macro and Micro if both happen within at most 2 years from each other. It follows that
reform X leads reform Y if it happened more than 2 years before reform Y.
micro nancial reforms.
4
Furthermore, micro nancial restrictions are in place long after
macro restrictions have been lifted.
5
This pattern is important because the sequencing of reform matters for growth. Table
2 shows that countries that do macro reforms before micro reforms tend to do worse in
terms of growth.
6
The omitted variable in this regression is a status quo situation. The
coecient associated with having macro reforms leading is negative and signicant at the
10% level. The (negative) coecient associated with having macro reforms leading other
reforms is dierent from the (positive) coecient associated with a composite alternative
sequencing strategy at the 5% level.
7
These negative eects are not surprising.
8
After all, lack of competition and missing
markets create distortions.
9
Why then do countries keep these distortions? And in partic-
ular, why do countries fully liberalize prices and quantities but are reluctant to introduce
competition in their nancial sector?
Table 1: Ordering of Liberalization
% of episodes in which following dimension (partially) liberalized rst
Regions Macro Reforms Micro Reforms Simultaneous
Advanced 57.6 15.1 27.3
Emerging Asia 81.9 5.6 12.5
Latin America 59.8 9.4 30.8
Sub-S. Africa 59.4 9.4 31.2
Transition 46.4 20.3 33.3
N. Africa & M. East 67.7 2.9 29.4
4
Table 10 in Appendix C collects regression results of Granger causality tests which conrm this
pattern.
5
Although the observation that macro reforms lead micro reforms is a new stylized fact, recent papers
on nancial reform already note that micro reforms targeting domestic nancial competition are less
correlated with overall nancial liberalization than other dimensions. See Abiad & Mody 2005 and Abiad
et al 2010.
6
I follow the approach of Bekaert et al (2005). The specication is given by:
j
i;t+k;t
= ,Q
i;1980
+
0
A
i;t
+c
0
1i/
i;t1
+c
0
oc
i;t
+-
i;t+k;k
where j
i;t+k;t
is the average growth over non-consecutive 5 year windows. Q
i;1980
represents logged G11
per capita in 1980, and the other controls (A
i;t
) include government spending as a percentage of G11,
proportion of secondary school enrollment, population growth and life expectancy. I perform a pooled
OLS regression where I test the impact of dierent nancial indices (1i/
i;t
= All, Macro, Micro) and
dierent sequencing strategies (oc
i;t
= MacroLead, MicroLead, Simultaneous).
7
This composite includes both the case where reforms are simultaneous and micro reforms happen
rst. Looking only at the situations where there was a reform in place, and taking the simultaneous case
as the omitted variable, the coecient on macro leading is -.011, and is signicant at the 5% level. The
coecients for the (positive) micro leading and the (negative) macro leading are dierent at the 5% level.
8
Bekaert et al (2005) studies equity market liberalizations and capital ows reform. In my work I
use a larger sample, and investigate a larger set of reforms. Furthermore, I explicitly study the growth
eect of dierent sequencing strategies. As appendix C shows, my results are consistent with Bekaert et
al (2005). Equity market liberalizations - an example of a micro nancial reform - are determinant for
growth, and capital ows reform - an example of a macro nancial reform - are not. Other micro and
macro nancial have quantitatively important eects that follow the pattern identied for equity markets
and capital ows.
9
Pasricha (2010) nds an empirical link between de facto integration and domestic nancial sector
competitiveness. Looking at deviations from the covered interest parity condition, she shows how the
lack of competition in domestic nancial systems may prevent countries from reaping potential benets
from nancial integration, as it induces deviations from price equalization.
2
Figure 1: All refers to the sample mean of all the entries of the nancial reform index
constructed by Abiad et al (2010). Macro reforms include capital account restrictions,
interest rate controls and credit controls. Micro reforms include entry in the nancial
sector, privatization, regulation and the establishment of equity markets. All sub-indices
take larger values if there is more liberalization, except for regulation and supervision,
where the opposite is true.
Table 2 (1) (2)
LaggedFinReform 0.000566** 0.000578**
(0.000278) (0.000278)
MacroLead -0.00726* -0.00718*
(0.00415) (0.00415)
MicroLead 0.00576 0.00591
(0.00878) (0.00879)
Simultaneous 0.00337 0.00317
(0.00489) (0.00491)
log1980 -0.0138*** -0.0133***
GovGDP -0.000552** -0.000483*
Secondary -0.00980 -0.00979
PopGr -1.014*** -1.038***
Log(life) 0.106*** 0.105***
Advanced -0.00286
Constant -0.286*** -0.288***
Observations 316 316
R-squared 0.337 0.338
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
3
I argue that a simple model of capital ows with domestic nancial intermediation
can explain these two patterns. A recent body of work led by Broner and Ventura (2010)
shows how models of capital ows where enforcement of nancial contracts is strategic
but it is hard to discriminate between domestic and foreign agents, can explain dierent
experiences with macro reforms.
10
The crucial element is that heterogeneity within the
economy creates domestic asset trade. Because it is hard to discriminate between domestic
and foreign asset trade, avoiding payments to foreigners implies destroying domestic asset
trade. There are two possible equilibria in this economy. In the optimistic equilibrium,
domestic savers save at home, entrepreneurs borrow domestically and abroad, investment
is large and there is no enforcement breakdown. In the pessimistic equilibrium, domestic
savers save abroad, entrepreneurs borrow abroad, and investment is small as there is
enforcement breakdown. In this view, capital ows reform allows more nancial trade
but worsens the strategic enforcement problem if trade with the rest of the world is too
large relative to domestic trade.
I take this perspective and introduce domestic nancial intermediaries as the sole
agents that can lend to entrepreneurs. On the contrary, savers can access international
markets without resorting to domestic nancial intermediaries. The second contribution
of this paper is to show that this asymmetry has important implications for the sequencing
of nancial reforms. In the model there are two policy dimensions. Like in Broner and
Ventura (2010), the domestic economy chooses whether there is free movement of capital
with the rest of the world. Unlike in Broner and Ventura (2010), the domestic economy
decides also on the level of competition in its nancial sector.
Imperfect competition is a distortion. It follows that in a rst best world it is never
optimal to restrain competition in domestic nancial markets. But the rst best is not
always attainable. The reasons behind this are traditional in the macroeconomic analy-
sis of developing economies and play an important role in my paper. First, there is an
externality among entrepreneurs that sometimes makes the good equilibrium impossi-
ble. Innitesimal entrepreneurs do not take into account the eect of their actions on
enforcement, and this leads to overborrowing. Second, there is a coordination problem
between savers that makes the pessimistic equilibrium always possible. Savers do not
internalize the eect of their actions on enforcement by the government. Third, there is
an underinsurance externality by domestic agents that do not internalize the impact of
their risk taking activities on government enforcement. Restricting competition alleviates
the strategic enforcement problem without fully compromising the inow of much needed
capital.
To keep the analysis simple, I study two limiting cases of domestic nancial compe-
tition. I assume that micro nancial policy determines if the nancial sector is either
perfectly competitive or a monopoly. In this framework, I show that if funds for invest-
ment are suciently scarce, the constrained optimal policy is to liberalize capital ows
while keeping a monopoly in the nancial sector. The intuition is that the monopolist has
a stake in the economy. In other words, the monopolist has its incentives aligned with
enforcement and partially corrects the externalities. Of course, this is not to say that the
monopolist charges the optimal mark-up or replicates the optimal plan of the economy.
10
The assumption of non-discrimination between domestic and foreigners has been recently used by
Kremer and Mehta (2000), Brutti (2010), Guembel and Sussman (2009), Broner and Ventura (2011),
Broner and Ventura (2010), Gennaioli, Martin and Rossi (2010), and Rappoport (2010). Broner et al
(2010) argue that this assumption can be rationalized with suciently deep secondary markets.
4
The monopolist only cares about maximizing prots. In fact, an optimal credit policy by
a government could always lead to the rst best, but the purpose of this paper is to study
situations where the government can not implement the rst best, and has to resort to
second best policies.
Crucially, the asymmetry of nancial intermediation explored in this paper also has
important predictions for the sequencing of nancial reform. If the international interest
rate is larger than the autarky interest rate, savers are better o following capital ow
liberalization even if they save domestically. This wealth eect of capital ow reform
paves the way to domestic nancial competition reform in a dynamic version of the model.
Richer savers reduce the amount of foreign nance needed by the country and this increases
the costs of enforcement breakdown. In other words, it makes some of the externalities
less important and tilts the policy towards liberalizing also the nancial sector. This way,
the model provides a rationale for the sequencing of nancial reform found in the data.
In the empirical part of the paper, I test the implications of the model. I perform
two types of test. I rst try to account for the observed sequencing in the data. The
model predicts that deep country characteristics that inuence the amount of domestic
savings relative to the need of intermediation determine the optimal sequencing of nancial
reform. Following Abiad and Mody (2005), I estimate a process for macro and micro
nancial reforms that is consistent with the model. I nd that nancial reform is not
completely exogenous and that lagged savings and credit have predictive power on which
reforms are implemented. Second, I come back to the growth regression presented in
Table 2. The model suggests that nancial reform is performed in a second best world.
Countries that do macro nancial reforms rst and only later introduce micro nancial
reforms would do even worse by performing them simultaneously. There is selection into
dierent sequencing strategies of nancial reform. I nd that this selection is correlated
with country characteristics suggested by the model. Introducing lagged deposits and
lagged credit in the growth regression presented in Table 2, I observe that the negative
growth eect associated with the macro-lead sequencing strategy disappears.
Other theories have been to proposed to explain some of the facts presented in this
paper. Ragan & Zingales (2003) suggest there are political economy factors behind the
timing of reform. With respect to this literature, this paper presents a rational alternative
that is complementary to the political economy of reform. In this paper it is the market
failure that induces the lack of reform, and not the political capture. Fernandez & Rodrik
(1991) present a learning story where successful initial reforms promote further reforms.
It does not explain which reforms should be implemented rst. The theory presented
in this paper suggests a pecking order for reforms that seems consistent with the data:
international capital ow liberalization should precede domestic nancial competition for
countries with low deposits but large need of nancial intermediation. This paper is then
related to the second best globalization works by Stiglitz (2000) and Caballero & Krish-
namurthy (2000, 2005) and Broner and Ventura (2010). Political economy explanations
of reforms associated with ideology nd mixed results (see Alesina & Roubini (1992) and
Bartolini & Drazen (1997)).
11
The rest of the paper proceeds as follows. Section 2 develops the model and discusses
the main results. Section 3 studies the determinants of nancial reform, and tests whether
11
My paper is also related to the study of cross-border nancial transactions with imperfect competition.
Paasche & Zin (2001) and Kletzer (1984) show how default externalities in sovereign lending make it
impossible to have an equilibrium with perfect competition.
5
the view presented in this paper can account for the negative growth eect described
above. Section 4 concludes and points to future research.
2 A model of macro and micro nancial reforms
I present a simple model of asset trade with heterogeneous agents: savers, entrepreneurs
and nancial intermediaries. In this model liberalization of capital ows represents macro
reforms and competition in the domestic nancial sector represent micro reforms.
12
I rst introduce dierent levels of competition on nancial autarky. Under nancial
autarky, capital is not allowed to ow from/to the domestic economy. This allows me
to illustrate the trade-os behind enforcement. I assume that enforcement maximizes
the average utility of the agents in the economy, excluding nancial intermediaries. Un-
der nancial autarky, enforcement breakdown only increases inequality between agents.
Furthermore, a monopolist simply extracts resources from the economy. Therefore it is
never optimal to do enforcement breakdown and as a consequence, to keep a monopolist
intermediary.
Then, I open this economy to capital ows, and compare the perfect competition
benchmark with the monopolist. I showhowa monopolist can do better when externalities
interact with enforcement breakdown. I consider three externalities: overborrowing by
entrepreneurs, coordination problems by savers and underinsurance. I nalize this section
by extending the model to introduce dynamics. I also discuss macro vs. micro nancial
reforms more generally. Finally, I draw empirical implications of the model, that I test in
the next section.
2.1 Preliminaries and autarky
There are three maximizing agents in this economy. Savers have funds but do not have
good investment opportunities. Entrepreneurs lack funds but have good investment op-
portunities. Domestic nancial intermediaries are the only agents that can lend to entre-
preneurs.
Institutional arrangements, such as the level of competition in the nancial sector and
liberalization of capital ows are determined by a forward looking calculation of average
welfare in the economy. They can not be overturned. On the contrary, contracts are
subject to an enforcement decision at 1 = 1 that is strategic. I assume that enforcement
of these contracts maximizes the utility of the average agent at 1 = 1. In other words, the
economy can commit to institutional arrangements but not to enforce nancial contracts.
There is one good that can be used for consumption, storage or investment. There are
two periods 1 = 0 and 1. In period 1 = 0, the economy rst decides on the institutional
arrangement: perfect competition vs. monopolist nancial sector, nancial autarky vs.
capital ow liberalization. Then, agents choose savings and investment decisions. In
period 1 = 1, enforcement of nancial contracts is strategic and chosen to maximize
average utility in that period. A crucial assumption is that enforcement of nancial
contracts can not discriminate between domestic and foreign agents.
13
There are two technologies in this economy, storage (|) and investment (/). Storage is
less productive than investment. Storage simply transfers resources across time without a
12
I discuss how representative these reforms are of micro and macro reforms in section 2.4.
13
EXPLAIN WHY IT IS CRUCIAL?
6
return. Investing | units of the good in storage today yields | units of the good tomorrow.
On the contrary, investment has a return. Investing / units of the good today, yields /

units tomorrow, where / is capital and 1, c (0. 1).

Savers and entrepreneurs are innitesimal and have masses (1 ) and , respectively.
Savers have funds. They can use the storage technology but not the investment tech-
nology. Entrepreneurs have insucient funds but can use the investment technology. A
crucial assumption is that only the nancial intermediary can lend to entrepreneurs. In-
termediaries choose their actions in order to maximize period by period prots. Savers
can deposit with the domestic nancial intermediary or with foreign banks, if capital ows
are liberalized. This asymmetry between the nancial trades of savers and entrepreneurs
plays a crucial role in my analysis, and can be justied by monitoring asymmetries. De-
posits do not need monitoring. But loans need to be monitored by a domestic nancial
intermediary who is subject to domestic law and therefore to strategic domestic enforce-
ment.
14
To summarize, at 1 = 0 there are four possible institutional arrangements:
A1 = (r. ) [r A = (Co:jctitio:. `o:ojo|) and 1 = (ntc:/. Ccjitc| 1|on:)
Institutional arrangements (r. ) are chosen to maximize:
l
0
= 1
0
[(1 ) ln (c
s
1
(1)) + ln (c
e
1
(1)) +o(1)] (1)
where o is the share of domestic intermediaries owned by domestic agents, are prots
of the domestic nancial sector and 1 summarizes the enforcement decision at 1 = 1. To
simplify, assume o = 0. I assume utility is of the log-type. Enforcement 1 can take two
values. If 1 = 1 there is enforcement of nancial contracts. If 1 = 0 there is enforcement
breakdown of nancial contracts and the economy is in a situation of widespread default.
Enforcement is strategic. In particular, it is chosen in period 1 to maximize average utility
of that period, given by:
l
1
= (1 ) ln (c
s
1
) + ln (c
e
1
) (2)
I will focus rst in a situation of nancial autarky. In the next subsection, I will
compare them with capital ow liberalization.
2.1.1 Perfect competition
The solution is obtained by backward induction. Under autarky enforcement breakdown
only generates inequality, without increasing average utility. This means that following
criteria (2), enforcement breakdown is never optimal and 1 = 1. It follows that having a
monopoly is never socially optimal.
Savers
Savers wish to maximize utility at 1 = 1. A saver receives an endowment in pe-
riod 0 and 1 of n
s
0
and n
s
1
, respectively. He has access to two investment options: (i) the
storage technology (|) transforms one unit of the good at time 0 into one unit at time
14
EXPLAIN WHY IT IS CRUCIAL?
7
1; and (ii) nancial trades with domestic intermediaries (/
s
0
), for a gross return of 1 in
period 1. Formally, a saver solves the following problem:
max
c
s
1
;b
s
0
, ln (c
s
1
)
s.t.
/
s
0
+ |
0
= n
s
0
c
s
1
= n
s
1
+ 1/
s
0
Given that there is no uncertainty, if 1 _ 1 storage is never optimal. Savings and
consumption are given by:
/
s
0
= n
s
0
(3)
c
s
1
(1 = 1) = n
s
1
+ 1n
s
0
(4)
c
s
1
(1 = 0) = n
s
1
(5)
In a symmetric equilibrium the total supply of funds is perfectly rigid and given by:
o = (1 ) n
s
0
(6)
Entrepreneurs
Entrepreneurs wish to maximize utility at 1 = 1. An entrepreneur receives an endow-
ment in period 0 and 1 of n
e
0
= 0 and n
e
1
, respectively. He has access to two investment
options: (i) an investment technology (/) that yields /

in period 1; and (ii) nancial

trades with domestic intermediaries (/
e
0
), for a gross return of 1 in period 1. Formally,
their problem is given by:
max
c
e
1
;k
e
0
;b
e
0
ln (c
e
1
)
s.t.
/
e
0
+ /
e
0
= 0
c
e
1
= n
e
1
+ (/
0
)

+ 1/
e
0
Entrepreneurs will borrow to equate the marginal return of investment to the marginal
cost. The solution to their problem is given by:
/
e
0
=
_
c
1
_ 1
1
(7)
/
e
0
= /
e
0
(8)
c
e
1
(1 = 1) = n
e
1
+ (1 c)
_
c
1
_
1
(9)
c
e
1
(1 = 0) = n
e
1
+
_
c
1
_
1
(10)
In a symmetric equilibrium, the aggregate demand of funds is given by:
1 =
_
c
1
_ 1
1
(11)
And it is possible to see that
@D
@R
< 0. The demand of funds is elastic and depends
negatively on the interest rate.
8
Figure 2: Perfect Competition: the interest rate that clears the market is given by 1
PC
.
Market clearing
Market clearing will determine the interest rate 1. It is dened as o = 1 or as
_
/
i
di = 0 :
(1 ) /
s
0
+ /
e
0
= 0 (12)
Solving for 1 :
1
A;PC
=
c
_
1"
"
n
s
0
_
1
(13)
Remember that storage is dominated by deposits only if 1 _ 1.
15
Under perfect
competition, intermediaries are completely passive and make zero prots. This setting
perfectly reproduces a market for bonds where entrepreneurs issue bonds and savers buy
these bonds from them. The solution is represented in Figure 2.
2.1.2 Monopoly
Suppose now that there is only one nancial intermediary. Under autarky, this nancial
intermediary will have both monopolist and monopsonistic powers. Therefore, one has to
distinguish between two contractual interest rates. Savers get 1
s
, which will also be the
marginal cost of funds for the monopolist. In autarky savers have no better outside option
other than storage. I assume that if they are indierent between storing or depositing they
deposit their funds. The monopolist will charge 1
e
to entrepreneurs. Then, the problem
of the monopolist is given by:
15
This is the case if (1 -) n
s
0
< -
_
A
1
_ 1
1
. I dene this as a situation where capital is scarce.
9
(1
s
. 1
e
) = arg max 1 (1
e
1
s
)
_
A
R
e
_ 1
1
s.t.

_
A
R
e
_ 1
1
_ (1 ) n
s
0
(`1)
1
e

_
_
A
R
e
_ 1
1
_
_
_
_
A
R
e
_
1
_
(`2)
1 = arg max
E=f0;1g
(1 ) ln (c
s
1
(1)) + ln (c
e
1
(1)) (`3)
c
s
1
(1) , c
e
1
(1) given by (4) . (5) and (9) . (10)
The rst constraint (`1) states that the monopolist can raise the funds it wishes
to supply. In this simple model, the supply of funds is xed if 1
s
_ 1. The second
constraint states that the monopolists total repayment is constrained by the total amount
of resources produced by entrepreneurs. The third constraint summarizes the enforcement
decision at 1 = 1. The monopolist only makes prots if 1 = 1, and he will take that into
account when choosing the interest rates. In this paper, I will be interested cases where
under autarky the monopolist is starving for funds. In this simple model this is the case
if the constraint (`1) is binding.
16
If the rst constraint is binding:
1
M;A
=
c
_
1"
"
n
s
0
_
1
(14)
Replacing it in (`2), it is possible to see that this is always feasible if c _ 1 and
is large enough. In this case, the monopolist only redistributes surplus. As savers have
no outside option, 1
s
= 1.
17
The solution is depicted in Figure 3. Monopolist prots are
given by:
= (1
e
1
s
) /
M
(15)
2.1.3 Policy and welfare
In both the perfect competition and the monopoly cases enforcement implies entrepreneurs
paying intermediaries who in turn pay the savers. Under autarky, enforcement breakdown
has no eect on average consumption and only negative eects on inequality. Therefore,
it is never optimal to do it. This further implies that the monopoly has no value under
autarky and perfect competition yields higher utility.
Let 1
PC;A
be the interest rate clearing the market under perfect competition, that
is, the interest rate that solves equation (13). Then, it is possible to compute welfare of
autarky under perfect competition as:
l
A;PC
1
= (1 ) ln (c
s
1
) + ln (c
e
1
) (16)
where,
16
This point holds in general if the supply of funds is upward slopping. This is the case if utility is not
of the log type.
17
There is no situation where no constraint binds. If ('1) is not binding, then ('2) is binding.
The largest interest rate possible the monopolist can charge is the one where it appropriates all of the
entrepreneurs revenues. This requires the monopolist to do price discrimination.
10
Figure 3: Monopoly: the interest rate that clears the market is given by 1
e
for entrepre-
neurs, and 1
s
for savers. The dierence corresponds to the monopolist spread.
c
s;A
1
= n
s
1
+
c
_
1"
"
n
s
0
_
1
n
s
0
c
e;A
1
= n
e
1
+ (1 c)
_
1

n
s
0
_

In this subsection I have shown that under nancial autarky, perfect competition is
the optimal institutional arrangement. In the next section, I will show conditions under
which the opposite holds when it is optimal to open to capital ows.
2.2 Capital ows liberalization
Assume now that there is a deep international market with no enforcement problems will-
ing to supply or demand funds in period 0 in exchange for a gross interest rate of 1

=
1 + : in period 1, and no barriers to asset trade. In case of enforcement breakdown I as-
sume that there is no penalty from abroad. Defaulting on contracts with the international
market comes with no externally imposed costs, but it can have internal costs. This is
the case because of the assumption that the government can not discriminate between do-
mestic and foreigners. Enforcement breakdown means also that planned domestic trades
are canceled.
18
In these conditions, enforcement only occurs if:
l
1
(1 = 1) _ l
1
(1 = 0) (17)
18
Under discrimination this model is just like the conventional view of capital ow liberalization and a
textbook monopoly.
11
Where l
1
(1) = ln (c
e
1
(1)) + (1 ) ln (c
s
1
(1)). The other crucial element is that
savers can deposit abroad or at home, but entrepreneurs have to borrow from domestic
intermediaries. With capital ow liberalization these intermediaries can now now obtain
deposits abroad or at home. Throughout, I will assume a symmetric equilibrium for all
agents in the economy.
19
Because of enforcement problems, agents in this economy face
dierent interest rates from their nancial trades with the international market. If an
agent is borrowing from abroad,
1
B;
(1) =
1 +:
Pr (1 = 1)
(18)
but if an agent is lending abroad,
1
L;
= 1 + : (19)
In this setting there are two possible equilibria that I label Pessimistic (1) and Opti-
mistic (C). In the optimistic equilibrium, savers save domestically and enforcement can
happen. In the pessimistic equilibria, savers save abroad and enforcement always breaks
down, independently of the level of competition. It follows that in order to have enforce-
ment, it is necessary that the deposits made by savers are subject to the enforcement
decision. But it is not sucient. The strategic enforcement will trade-o these costs of
enforcement breakdown, borne by savers, with the benets accruing to entrepreneurs. In
case of enforcement breakdown entrepreneurs do not have to pay back for the capital they
invested.
For an optimistic equilibrium to exist, entrepreneurs must not commit to too many
payments abroad. Because they are atomistic they do not internalize the eects of their
individual actions in the enforcement strategy followed at 1 = 1. I refer to this as the
overborrowing externality. Savers are also atomistic and follows the sunspot variable
unless domestic nancial intermediaries oer them better conditions. I refer to that as the
coordination problem.
Assume that which equilibrium is played depends on the realization of a sunspot
variable at t = 0 given by = (C. 1), with probabilities Pr ( = C) = 1 j and
Pr ( = 1) = j. I assume that the sunspot is revealed and perfect observable as of
1 = 0, but only after the institutional arrangement is in place. I will further assume that
this sunspot does not depend on the institutional arrangement. In order to distinguish
between domestic and foreign trades, let / stand for domestic nancial trades and , for
foreign trades.
In what follows, I will show conditions under which each of these equilibria exists.
2.2.1 Perfect competition
Under perfect competition, the nancial sector is composed by an innite number of atom-
istic intermediaries. In this case, the sunspot variable crucially determines the outcome
of this economy. In particular, it is possible to show that there always exists a pessimistic
equilibrium and that the existence of the optimistic equilibrium is not always guaran-
teed. The amount of savings and the entrepreneurs outside option following enforcement
breakdown at 1 = 1 crucially determine whether this optimistic equilibrium exists.
19
To simplify the description of the equilibrium, assume that gross positions are minimized.
12
Lemma 1 There is always a pessimistic equilibrium where /
0
= 0 and ,
0
= 0.
Proof. Suppose all savers deposit abroad and all intermediaries catering entrepreneurs
borrow from abroad. Then, because enforcement is strategic, enforcement only implies
a transfer of resources abroad, and there is enforcement breakdown. Since contracts are
never enforced, the interest rate 1
B
(1) = , and investment is zero.
If the pessimistic equilibrium is played, consumptions are given by:
c
s
(1. 1 = 0) = n
s
1
+ (1 + :) n
s
0
(20)
c
e
(1. 1 = 0) = n
e
1
(21)
Welfare is then given by:
l
P
1
= (1 ) ln (n
s
1
+ (1 + :) n
s
0
) + ln (n
e
1
) (22)
In an optimistic equilibria savers deposit domestically, and intermediaries complement
these funds with foreign borrowing to supply entrepreneurs. Enforcement is optimal. In
this equilibrium, enforcement breakdown would destroy so much domestic asset trade that
this does not compensate avoiding payments abroad. Then:
1
B;
(1 = 1) = 1 +: (23)
domestic deposits are again given by:
/
s
0
= n
s
0
(24)
and borrowing by entrepreneurs and intermediaries is given by
/
e
0
=
_
c
1 +:
_ 1
1
(25)
,
e
0
= /
s
0

_
c
1 +:
_ 1
1
(26)
At 1 = 1, consumption under enforcement and under enforcement breakdown are
given by:
c
s
(C. 1 = 1) = n
s
1
+ (1 + :) n
s
0
(27)
c
s
(C. 1 = 0) = n
s
1
(28)
c
e
(C. 1 = 1) = n
e
1
+ (1 c)
_
c
1 +:
_
1
(29)
c
e
(C. 1 = 0) = n
e
1
+
_
c
1 +:
_
1
(30)
13
Enforcement breakdown hurts savers and benets entrepreneurs. If 1 = 0, savers lose
(1 +:) n
s
0
and entrepreneurs win c
_
A
1+r
_
1
. The condition determining the existence
of this equilibrium is then given by:
(1 ) ln (n
s
1
+ (1 + :) n
s
0
) + ln
_
n
e
1
+ (1 c)
_
c
1 +:
_
1
_
(31)
_ (1 ) ln (n
s
1
) + ln
_
n
e
1
+
_
c
1 +:
_
1
_
The following lemma shows that the existence of the optimistic equilibrium depends
crucially on domestic savings and on entrepreneurs need of credit. Observing equation
(31) it is possible to see that if n
s
0
is suciently large, this equilibrium always exists.
Finally, the need of intermediation also plays a role, in particular if
A
1+r
is too large, this
inequality will not hold and the optimistic equilibrium does not exist.
Lemma 2 The optimistic equilibrium exists if (31) is satised.
Proof. The proof follows from the analysis above.
If the optimistic equilibrium exists, welfare is given by:
l
O
1
= (1 ) ln (n
s
1
+ (1 + :) n
s
0
) + ln
_
n
e
1
+ (1 c)
_
c
1 +:
_
1
_
(32)
When deciding to liberalize competition the relevant welfare associated with a situation
of perfect competition with capital ow liberalization is then:
\
PC
1
= (1 j) l
O
1
+ jl
P
1
Which can be rewritten as:
\
PC
1
= (1 ) ln (n
s
1
+ (1 + :) n
s
0
) +

_
j ln (n
e
1
) + (1 j) ln
_
n
e
1
+ (1 c)
_
c
1 +:
_
1
__
It is possible to see that savers are not aected by which equilibrium is played. The
welfare of entrepreneurs is decreasing in the probability of a pessimistic equilibrium j.
2.2.2 Monopoly
A monopolist cares about prots but can internalize the behavior of atomistic agents.
If prots are maximized under enforcement he will attract domestic savings by paying
a slightly larger interest rate on its domestic depositors and induce enforcement. The
presumption is that a monopolist can engage in ex-ante discrimination between domestic
14
and foreign depositors. On the other side of the market, the monopolist will constrain
lending, if necessary, to make sure that the optimistic equilibrium exists. Of course, if
prots are higher under enforcement breakdown, he will arrange for that equilibrium to
be played.
This section contains the two main results of this paper: (i) the incentives of the
monopolist are aligned with enforcement and (ii) under some conditions it is better to
keep a monopolist intermediary following the opening to capital ows. The intuition for
the incentives of the monopolist to be aligned with enforcement is simple. He benets
more when he gets repaid. The monopolist extracts rents from the economy so prefers a
situation where the size of the economy is larger. These rents come with a dead weight
loss, a consequence of the monopolist markup. The benets associated with enforcement
under a monopolist need to be compared with the lottery under perfect competition.
The problem of the monopolist looks very similar to the one under autarky, except
that now there are no constraints on the amount of funds he has access to. Furthermore,
the marginal cost of funds is larger. The problem can be summarized as:
(1
s
. 1
e
) = arg max 1 (1
e
1
s
)
_
A
R
e
_ 1
1
s.t.
1
e

_
A
R
e
_ 1
1
_
_
A
R
e
_
1
(`2)
1 = arg max
E=f0;1g
(1 ) ln (c
s
1
(1)) + ln (c
e
1
(1)) (`3)
c
s
1
(1) , c
e
1
(1) given by (4) . (5) and (9) . (10)
The monopolist understands that if the pessimistic equilibrium is played, enforcement
breaks down. In that case 1 = 0, and prots are zero. It will then do the best he
can to keep savings subject to the enforcement decision. In order to attract savings, the
monopolist has to oer savers 1
s
= 1 + :. Remember that I assumed that if indierent,
savers keep their savings domestically. The monopolist must also guarantee that these
are not tradable deposits abroad. In order words, the monopolist must be able to engage
in ex-ante discrimination between domestic and foreigners.
20
The marginal cost of funds
of the monopolist is now 1 +: while 1
e
is charged on rms. Suppose that (`2) does not
bind and that 1 = 1. The solution is represented in Figure 4. It is possible to show that:
1
s
= 1 + :
1
e
=
1 +:
c
(33)
If with the interest rate 1
e
given by equation (33) there is no enforcement and 1 = 0,
the monopolist will increase it further to ensure that enforcement occurs.
21
Note that the
monopolist gets no prots in the non-enforcement equilibrium. This point is more general
than the simple model studied here. It is possible to show that for any positive probability
that enforcement is always guaranteed at 1 = 1, the monopolist makes prots even if non-
enforcement is a possible outcome, but it still favors enforcement. The intuition for this
result is that the monopolist has a stake on the enforcement decision. It follows that the
monopolist will try to induce it.
20
One way to implement this is to oer large interest rates for long term savings deposits with penalties
for early withdrawal. This eectively works like a tax on capital outows.
21
This occurs if PUT CONDITION HERE.
15
Figure 4: Capital Flow Liberalization with Perfect Competition and with Monopoly.
This section argues that the monopolist can potentially solve the two externalities
present in the perfect competition case. First, the monopolist can always reduce entrepre-
neurial borrowing to satisfy the condition that the optimistic equilibrium exists. Second,
if the monopolist can ex-ante discriminate, it can eliminate pessimism altogether. By
making sure that domestic savings are invested domestically, the monopolist coordinates
savers towards a situation that is independent of the sunspot variable .
The next section studies the conditions, under the dierent roles of the monopolist,
that determine the optimal institutional arrangement at 1 = 0.
2.3 Optimal institutional arrangements
2.3.1 Constraining trade
Assume that the monopolist can not engage in ex-ante discrimination. Then the mo-
nopolist can at least constrain credit. To see this role of the monopolist, compare the
conditions guaranteeing the existence of the optimistic equilibrium under perfect competi-
tion and monopoly. Let :c and c:cd represent the amount of savings from one saver and
the amount of funds lent to one entrepreneur, respectively. These conditions are given
by the following two inequalities, where 1C represents perfect competition, and ` the
monopolist situation:
(1 ) ln
_
n
s
1
+ (1 + :) :c
PC
0
_
+ ln
_
n
e
1
+ (1 c)
_
c:cd
PC
0
_

_
(34)
(1 ) ln (n
s
1
) + ln
_
n
e
1
+
_
c:cd
PC
0
_

_
16
(1 ) ln
_
n
s
1
+ (1 + :) :c
M
0
_
+ ln
_
n
e
1
+ (1 c)
_
c:cd
M
0
_

_
(35)
(1 ) ln (n
s
1
) + ln
_
n
e
1
+
_
c:cd
M
0
_

_
In this simple model, savings are inelastic and :c
PC
0
= :c
M
0
= n
s
0
, but the monopolist
can always reduce credit suciently to ensure that this condition holds. Suppose that this
is given by the unconstrained solution to the monopolist problem given by (33). Then
c:cd
M
0
=
_

2
A
1+r
_ 1
1
< c:cd
PC
0
=
_
A
1+r
_ 1
1
. It is possible to see that the inequality holds
for a larger conguration of parameters under monopoly than under perfect competition.
In other words, under a monopolist there are lower levels of savings such that the equality
holds. Formally, dene n
s
0
PC
and n
s
0
M
that make the inequalities (34) (35) exactly zero.
It is immediate to see that n
s
0
PC
n
s
0
M
. It follows from the simple structure of this
model that if the monopolist can only constrain trade, a monopolist is only constrained
optimal when the optimistic equilibrium under perfect competition does not exist.
Focus now on condition (34). Rewrite it as :
(1 ) ln
_
n
s
1
+ (1 + :) :c
PC
0
_
(1 ) ln (n
s
1
)
ln
_
n
e
1
+
_
c:cd
PC
0
_

_
ln
_
n
e
1
+ (1 c)
_
c:cd
PC
0
_

_
The right hand side is increasing in
_
c:cd
PC
0
_

. To see this, dierentiate it with respect

to c:cd
PC
0
:

c
_
c:cd
PC
0
_

n
e
1
+ (c:cd
PC
0
)

c(1 c)
_
c:cd
PC
0
_

n
e
1
+ (1 c) (c:cd
PC
0
)

0
It it possible to show that if c 0, this condition is positive. In other words, the
inequality is harder to satisfy the larger is credit in the economy.
2.3.2 Ex-ante discrimination
Assuming that the monopolist can ex-ante discriminate between domestic and foreign
depositors, the relevant trade-o at 1 = 0 is between the sure distorted welfare of the
monopoly, and the lottery that comes with perfect competition. In this case, the mo-
nopolist makes sure that savings are deposited domestically. In the previous section, I
have argued that the optimistic equilibrium always exists under a monopoly. The relevant
trade o is then:
\
M
0
_ (1 j) l
O
1
+ jl
P
1
(36)
where l
O
1
is given by equation (32), l
P
1
by equation (22) and, \
M
0
is the value at 1 = 0
of a monopolist and is given by:
\
M
0
= (1 ) ln (n
s
1
+ (1 + :) n
s
0
) + ln
_
n
e
1
+ (1 c)
_
c
2

1 +:
_
1
_
in the unconstrained solution of the monopolist. Simplifying, (36) can be rewritten:
ln
_
n
e
1
+ (1 c)
_
c
2

1 +:
_
1
_
_ (1 j) ln
_
n
e
1
+ (1 c)
_
c
1 +:
_
1
_
+jln (n
e
1
)
17
2.3.3 Underinsurance
[To Be Completed]
2.3.4 Sequencing of reform
[To Be Completed]
Suppose there are 3 periods in this economy. The additional period 1 = 2 is just a
replica from 1 = 1. At 1 = 1, before new borrowing and lending is done but after the
enforcement decision, it is possible to change the institutional arrangement in the economy.
We have seen before that the crucial determinants behind the trade-o between perfect
competition and monopoly, given capital ow liberalization, are savings and credit. If the
monopolist can not discriminate, then a monopolist is only preferable if savings are small
enough. If the monopolist can discriminate, savings are irrelevant and deep parameters
determining credit are crucial for the trade-o.
Suppose that we are in an economy that at 1 = 0 opens to capital ows but keeps
a monopolist nancial intermediary. Assume further that this monopolist can constrain
nancial trade in the economy but it can not ex-ante discriminate between savers. This
section argues that at 1 = 1 the benets from having a monopolist are smaller. One
of the consequences of the asymmetry in intermediation studied in this paper is that
opening to capital ows always makes savers better o. This wealth eect, everything
else equal, makes the trade-o between perfect competition and monopolist easier. It
can then tilt the balance of nancial reform also towards the introduction of domestic
nancial competition.
2.4 Discussion and empirical implications
If the economy is capital scarce, I have identied three socially valuable roles for a monop-
olist. All are classic second best arguments. The monopolist has a stake on enforcement.
This is because only through enforcement the monopolist can extract rents from the
economy.
22
First, if a monopolist can discriminate ex-ante between domestic and foreign
savers he will be interested in keeping domestic savings subject to the enforcement deci-
sion.
23
Second, even if the monopolist can not discriminate between savers, it can make
the optimistic equilibrium possible by constraining the amount of funds supplied to the
entrepreneurial sector. In a situation where enforcement would breakdown under perfect
competition because there is over-borrowing, a suciently large monopolist mark-up can
correct these imbalances. Third, to the extent that the monopolist can use the monitor-
ing technology to adequately spread risk, the monopolist can solve the underinsurance
externality.
In the model I have focused on capital ows and domestic competition but many other
reforms can be thought as having similar eects. For example, other macro restrictions
22
This complementarity between private agents actions and enforcement is also present in Brutti (2009)
and Gennaioli, Martin and Rossi (2011), in a dierent formulation. Furthermore, these two papers focus
on the sustainability of public debt.
23
This notion of ex-ante discrimination is considered in Broner & Ventura (2011) as a desired policy by
a Government. They conclude that this assumption goes against the non-discrimination assumption that
is crucial for their analysis. In my paper, I keep the non-discrimination assumption by the Government,
but allow the nancial intermediaries to perform ex-ante discrimination. That is, the monopolist can
target their activities and induce domestic agents to save with them.
18
such as restrictions on the interest rate and on the quantity of credit, can be thought of as
limits on the amount of funds that can be traded in the economy. In a perfect competition
world these can reduce the amount of intermediation but will not necessarily correct the
externalities I discuss in the model. Regarding micro restrictions, the establishment of
equity markets can be thought of as an increase of competition. Equity markets allow
rms to get funds in the stock market, directly from savers. Therefore, this reform is very
similar to introducing competition in the nancial sector, if debt and equity are perfect
substitutes. Regulation and supervision introduce checks on market power.
Although quite stylized, this model has some interesting empirical implications to
study nancial liberalization. From an ex-ante perspective, the model suggests that open-
ing to capital ows and to competition should depend on the ability to raise domestic
savings and on how large the entrepreneurial sector is. From an ex-post perspective, the
model suggests that opening up to capital ows should increase credit more if there is
perfect competition in the domestic nancial sector. When there is lack of competition,
opening to capital ows might even decrease credit.
Finally, the model predicts that countries that are open to international nancial
markets but have lower domestic nancial competition are less subject to capital ow
reversals. A simple extension with a positive probability that enforcement is always
guaranteed yields the prediction that crises happen only if there is sucient competition
in the domestic nancial sector. The following section turns to the data to see which
elements of the model are consistent with the data.
3 Empirical analysis
There are two approaches to empirical work on nancial reform. One strand of litera-
ture assumes reform is exogenous and studies the causal eects of nancial liberalization.
Another strand takes the view that liberalization is endogenous and looks for the determi-
nants of reform and reversals.
24
In this section, I perform both types of tests. I rst focus
on the determinants of nancial reform. To do so, I take advantage of the new dataset
on nancial reform proposed by Abiad et al (2010) and I follow the analysis of liberaliza-
tions and reversals proposed by Abiad & Mody (2005). I nd that relevant variables in
the model - savings and credit - help determine nancial reform of dierent dimensions.
This suggests that nancial reform, and in particular, dierent sequencing strategies of
nancial reform are not exogenous. If reform is endogenous then I then introduce lagged
savings and credit in the growth regression and note that this absorbs the negative growth
eect associated with doing macro nancial reforms before micro nancial reforms.
3.1 Data
3.1.1 The Abiad et al (2010) index of nancial reform
The main innovation of this index is its breakdown of reform in seven dierent dimen-
sions of nancial sector policy: (1) capital account restrictions, (2) credit controls and
24
These two views are not necessarily opposites. For reforms to be exogenous they must be unexpected,
or their eects should not be felt before they are in place. For the two views to be possible, all that is
necessary is that the window of opportunity for reform to be exogenous, but the actual decision to be
endogenous, which is the view this paper takes.
19
excessively high reserve requirements, (3) interest rate controls, (4) entry barriers, (5)
state ownership in the banking sector, (6) prudential regulations and supervision of the
banking sector and (7) equity market policy. Along each dimension, a country was given
a score on a graded scale from zero to three, with zero corresponding to repression and 3
indicating full liberalization. This index is available for a sample of 91 countries over the
period 1973-2005.
Financial reform is a complex phenomenon, making it hard to isolate the eects of
dierent policies. For instance, targeted policies have consequences across the board as
they aect all the other dimensions of nancial reform. Reforms from foreign countries
have an impact on domestic policies, and even technological change can determine how
restrictive some policies are. With these caveats in mind, I use this index of nancial
reform and separate it between micro (1 4) and macro reforms (5 7). I construct the
following two indices:
:cc:o
t
=
ccjitc| ,|on:
t
+ c:cdit co:t:o|:
t
+ i:tc:c:t :ctc co:t:o|:
t
3
:ic:o
t
=
c:t: /c::ic::
t
+ :tctc on:c::/ij
t
+ :cqn|ctio:
t
+ cnit :c:/ct:
t
4
3.1.2 The Beck & Kunt database on nancial development and structure
This dataset has been used much more than the previous dataset so it needs a smaller
introduction. It contains indicators of nancial development and structure across countries
from 1960-2007. From this is very rich dataset, in this preliminary analysis, I extract data
on credit, domestic deposits and concentration of the banking sector.
3.2 Determinants of Financial Reform
In this section I study the eect of the variables predicted by the model in overall nancial
liberalization. The reason to focus on the general index, instead of focusing directly on
individual index levels or in the macro and micro division, is that nancial reform is a
complex process, and its dimensions interact in dierent ways. Policy measures destined
to aect the way nancial trade is done domestically have an impact on how nancial
trade is performed across borders, and vice-versa. Then, it makes sense to take advantage
of the larger variation and information available by looking at the overall level of nancial
reform rst. I then perform the same analysis for dierent types of reform.
The analysis in Abiad & Mody (2005) assumes the following process for nancial
reform, where 11

is the desired level of nancial liberalization - aggregate or of a given

index - and c is a measure of the status quo bias:
11
it
= c
_
11

it
11
i;t
1
_
+
it
(37)
In the benchmark specication, Abiad & Mody (2005) assume the desired level of
nancial liberalization to be 1 for all countries (the maximum). This paper suggests that
this level should depend on how much the economy saves, and how much credit there is
in place.
11

it
= c
1
G11
i;t
+ c
2
1cjo:it:
i;t1
+ c
3
C:cdit
i;t1
20
From Abiad & Mody I keep the assumption that there is a domestic learning process
in place, and choose c = 11
i;t1
, and that there is a regional learning process in place,
captured by the introduction of distance to the regional leader in reform:
11
it
= o
1
11
i;t1
+ o
2
11
i;t1
G11
i;t
+
o
3
1cjo:it:
i;tx
11
i;t1
+
o
4
C:cdit
i;tx
11
i;t1
+ o
5
11
2
i;t
1
+
o
6
(11G_11
i;t1
11
i;t1
) +
it
(38)
The model suggests o
1
. o
2
0 and o
3
. o
4
< 0. Regional learning suggests o
5
0. Table
3 presents the results for regressions that use the ordered logit technique applied in Abiad
& Mody (2005) for developing economies. I combine the sample in Abiad & Mody (2005)
and Abiad et al (2010) with the dataset on nancial development and structure. The
results presented in Table 3 are suggestive of the mechanisms of the model at work: for a
given level of nancial reform in place, large deposits facilitate nancial reform and large
credit hinders nancial reform.
Table 3: Ordered Logit (1) (2) (3) (4)
l.indx 5.173*** 5.345*** 5.392*** 5.371***
(0.820) (0.838) (0.838) (0.833)
l.indx^2 -6.098*** -6.152*** -6.178*** -6.175***
(0.940) (0.951) (0.949) (0.946)
l.indx*GDP 3.15e-05*** 5.34e-05** 6.31e-05*** 6.17e-05***
(1.15e-05) (2.12e-05) (1.99e-05) (1.98e-05)
l.indx*Dep -0.704* 0.340
(0.421) (0.534)
l.indx*Cred -1.108** -1.427**
(0.430) (0.619)
RegCatchup 1.177** 1.205** 1.150** 1.128**
(0.530) (0.530) (0.540) (0.533)
Observations 1272 1272 1272 1272
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
The ordered logit specication is appropriate for a dependent variable that takes a
discrete number of values, and where the changes represent discrete jumps. Both this
specication and Abiad and Mody (2005) use as a dependent variable the average value
of the nancial index, which takes many values from 0 and 1. Although this variable
is not cardinal, it is hard to understand it as a purely ordinal variable, as the simple
average treats changes in dierent indices equally. Besides, the ordered logit specication
introduces assumptions about the distribution of these variables and has hard to interpret
coecients. To conrm the results, Table 4 presents the results of an OLS specication
which are very much in line with the ordered logit regression.
21
Table 4: OLS (1) (2) (3) (4)
l.indx 0.101*** 0.101*** 0.103*** 0.102***
(0.0198) (0.0203) (0.0204) (0.0202)
l.indx^2 -0.140*** -0.140*** -0.140*** -0.140***
(0.0213) (0.0213) (0.0215) (0.0211)
l.indx*GDP 7.90e-07*** 8.56e-07** 1.14e-06** 1.03e-06**
(2.61e-07) (4.18e-07) (4.38e-07) (4.18e-07)
l.indx*Dep -0.00212 0.0183*
(0.00909) (0.0102)
l.indx*Cred -0.0123 -0.0285**
(0.0105) (0.0129)
RegCatchup 0.0276* 0.0277* 0.0275* 0.0263*
(0.0142) (0.0143) (0.0142) (0.0142)
Observations 1272 1272 1272 1272
R-squared 0.065 0.065 0.066 0.067
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
3.2.1 No eect on macro reforms, but important eect on micro reforms
I now perform two regressions on the macro and micro indices, assuming the process
represented by (38). Tables 5 and 6 show that the variables predicted by the model,
deposits and credit, matter crucially for micro reforms but not for macro reforms. Note
that deposits and credit are not signicant when accounting for macro reforms, but they
are jointly signicant for micro reforms (although deposits is not signicant individually).
These results further suggest that credit is the crucial variable determining dierent reform
strategies.
Table 5: Macro Reforms (1) (2) (3) (4) (5)
l.indx 0.148 0.155 0.160 0.157 0.150
(0.102) (0.105) (0.105) (0.105) (0.107)
l.indx*l.indx -0.317*** -0.320*** -0.322*** -0.321*** -0.321***
(0.100) (0.101) (0.102) (0.102) (0.103)
l.indx*gdp4 3.62e-06*** 4.60e-06* 5.39e-06** 5.14e-06** 5.12e-06**
(1.35e-06) (2.40e-06) (2.35e-06) (2.29e-06) (2.33e-06)
l.indx*l.dep -0.0308 0.0496 0.0524
(0.0461) (0.0577) (0.0581)
l.indx*l.cred -0.0617 -0.108 -0.111
(0.0497) (0.0685) (0.0687)
catchup_ind 0.136** 0.137** 0.133** 0.130* 0.132*
(0.0649) (0.0661) (0.0660) (0.0665) (0.0667)
Observations 1272 1272 1272 1272 1272
R-squared 0.041 0.041 0.042 0.042 0.042
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
22
Table 6: Micro Reforms (1) (2) (3) (4) (5)
l.indx 0.413*** 0.431*** 0.435*** 0.433*** 0.432***
(0.0555) (0.0581) (0.0572) (0.0569) (0.0607)
l.indx*l.indx -0.424*** -0.430*** -0.432*** -0.432*** -0.432***
(0.0617) (0.0647) (0.0636) (0.0629) (0.0629)
l.indx*gdp4 1.31e-06 3.62e-06** 4.47e-06*** 4.32e-06*** 4.31e-06***
(8.98e-07) (1.43e-06) (1.37e-06) (1.34e-06) (1.35e-06)
l.indx*l.dep -0.0730** 0.0301 0.0307
(0.0301) (0.0356) (0.0377)
l.indx*l.cred -0.110*** -0.138*** -0.139***
(0.0348) (0.0494) (0.0508)
catchup_ind 0.0768* 0.0792* 0.0726* 0.0706* 0.0710*
(0.0433) (0.0416) (0.0419) (0.0417) (0.0422)
Observations 1272 1272 1272 1272 1272
R-squared 0.029 0.034 0.038 0.038 0.038
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
3.3 Ex-post results
3.3.1 Accounting for the negative growth eect of sequencing
In this section I redo the analysis in Table 2, introducing credit and deposits in the
analysis. Remember that average growth was computed as a 5 year window, therefore,
credit and deposits are timed one period before this 5 year window. Table 7 collects
the results. Columns (1)-(2) are reproduced from Table 2. Columns (3)-(4) add lagged
savings as an explanatory variable. Note that the coecient on the sequencing with
macro leading is reduced, and now insignicant. There is a positive and signicant eect
of lagged savings on growth. This is consistent with the model. [To Be Completed]
23
Table 7 (1) (2) (3) (4)
LaggedFinReform 0.000566** 0.000578** 0.000593** 0.000606**
(0.000278) (0.000278) (0.000277) (0.000278)
MacroLead -0.00726* -0.00718* -0.00678 -0.00669
(0.00415) (0.00415) (0.00414) (0.00415)
MicroLead 0.00576 0.00591 0.00584 0.00599
(0.00878) (0.00879) (0.00875) (0.00876)
Simultaneous 0.00337 0.00317 0.00390 0.00369
(0.00489) (0.00491) (0.00489) (0.00490)
LaggedSavings 0.0229* 0.0232*
(0.0135) (0.0135)
log1980 -0.0138*** -0.0133*** -0.0141*** -0.0135***
GovGDP -0.000552** -0.000483* -0.000503* -0.000429
Secondary -0.00980 -0.00979 -0.0109 -0.0109
PopGr -1.014*** -1.038***
Log(life) 0.106*** 0.105*** 0.0995*** 0.0987***
Advanced -0.00286 -0.00308
Constant -0.286*** -0.288*** -0.261*** -0.263***
Observations 316 316 316 316
R-squared 0.337 0.338 0.343 0.344
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
3.3.2 Enforcement crises and concentration of the banking sector
The nal tests are ex-post results. In a liberalized economy, does concentration predict a
lower frequency of defaults?
Pr(1c,cn|t) = 1
_

t
+ ,
1
1cjo:it:
i;t1
+ ,
2
C:cdit
i;t1
+ ,
3
Co:cc:t:ctio:
i;t1
+ A
0
i;t1

_
Table 8 and 9 show that both the de jure index for concentration and a de facto
measure of (lagged) concentration of the nancial sector suggest that higher concentration
is associated with a lower enforcement crisis, which is another prediction of the model. In
particular, these p
Table 8: Probit (1) (2) (3) (4)
L.Deposits -2.372*** -2.720*** -2.720***
L.PrivCredit 1.279*** 1.394** 1.369**
L.concentration -0.575 -0.808* -0.822*
L.growth -7.445*** -7.248*** -7.454*** -7.262***
L.curracc 0.00987 0.0163 0.0155 0.0160
L.reserves -6.014 -3.587 -4.712 -4.477
L.BankCrisis 0.203
Observations 1306 1306 1306 1306
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
24
Table 9: Probit (1) (2) (3) (4) (5)
L.entr 0.172* 0.170*
L.indx -1.091** -0.473 -0.537 -0.549 -1.165**
L.growth -5.929*** -6.312*** -6.149*** -6.063*** -5.653**
L.curracc -0.0299** -0.0361** -0.0369** -0.0353** -0.0316**
L.reserves -0.526 -1.543 -1.823 -1.465 -1.211
L.bdgdp 0.322 -0.480 -0.378
L.pcrdbgdp 0.530* 0.834* 0.790
Observations 1226 1226 1226 1226 1226
Robust standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
4 Conclusion
This paper presents a stylized model that highlights two reasons why restricting domestic
nancial competition when opening up to capital ows might be a desirable policy mix.
A rst pass at the data suggests that these mechanisms are important empirically, but
also unveils a more general view that the sequencing of reforms matters empirically, and
that there is an important distinction between reforms that target quantities and prices
in nancial markets (macro) and reforms that deal with the structure of nancial markets
(micro reforms).
Future research should study the robustness of the mechanism. Theoretically, this
simple model can be explored in the context of a dynamic stochastic general equilibrium
framework. Furthermore, there are other reasons why domestic nancial competition
might be hurtful when opening up to capital ows. The debate on competition and
stability in the banking sector is a important explanation (see Beck (2008) for a survey). It
follows then that a general model of competition and capital ow liberalization should add
these to the mechanisms considered in this paper, and evaluate the relative contribution
of complementary explanations.
The biggest challenge lies with empirical work. This paper has presented some sug-
gestive evidence but if stops short of a full test of the theory. Although the episodes
and regressions presented in Section 3 seem to support the view that macro nancial
liberalization interacts with domestic nancial competition in non-trivial ways, the role
of competition remains hard to discern empirically. One diculty with the data is that it
is hard to measure competition in the nancial sector. Also, a formal test of this theory
should account for the dierent episodes and for the complementary political economy
considerations that have dominated the literature thus far.
As the world economy exits the most important crisis since the great depression and
nds itself struggling with a backlash against market-based nancial reforms, the under-
standing of the optimal policy mix and timing of dierent reforms is of incalculable value.
The last 40 years have been rich in dierent experiences with reform and reversals which
provides economists with a laboratory to study the theory of nancial reform. For these
reasons, the topics addressed in this paper remain an interesting eld for future research.
25
5 References
Abiad A, Mody A. 2005. Financial reform: what shakes it? what shapes it? American
Economic Review 95, 6688
Abiad, A, & Detragiache, E. & Tressel, T., 2010. "A New Database of Financial
Reforms," IMF Sta Papers, 57(2), pages 281-302, June.
Alesina, A. and Roubini, N., 1992. "Political Cycles in OECD Economies",
Review of Economic Studies, 59(4), pages 663-88.
Bandiera, O. & Caprio, G. & Honohan, P. & Schiantarelli, F., 2000. "Does
Financial Reform Raise or Reduce Saving?," The Review of Economics and Statistics, vol.
82(2), pages 239-263, May.
Bartolini, L. & Drazen, A. 1997. "When Liberal Policies Reect External Shocks,
What Do We Learn?", Journal of International Economics, 42(3-4), pp. 249-73.
Beck, T., 2008. "Bank competition and nancial stability : friends or foes ?,"Policy
Research Working Paper Series 4656, The World Bank.
Beck, T. and Demirg-Kunt, A. 2009. "Financial Institutions and Markets
Across Countries and over Time: Data and Analysis", World Bank Policy Research Work-
ing Paper No. 4943
Broner, F. and Ventura, J., 2010. "Rethinking the eects of nancial liber-
alization," Economics Working Papers 1128, Department of Economics and Business,
Universitat Pompeu Fabra, revised Dec 2010.
Brutti, F. 2011. Legal Enforcement, Public Supply of Liquidity and Sovereign
Risk, Journal of International Economics, Vol. 84, Issue 1, May 2011, Pages 65-72
Fernandez, R. and Rodrik, D., 1991. "Resistance to Reform: Status Quo Bias
in the Presence of Individual-Specic Uncertainty", American Economic Review, 81(5),
pages 146-55.
Gennaioli, N., Martin, A. and Rossi, S., 2011. Sovereign Default, Domestic
Banks and Financial Institutions(Manuscript)
Guembel, A. and Sussman, O., 2009. Sovereign Debt Without Default Penal-
ties, Review of Economic Studies, 76, 12971320
Kletzer, K., 1984. "Asymmetries of Information and LDC Borrowing with Sovereign
Risk," The Economic Journal, Vol. 94, No. 374, pp. 287-307.
Kremer, M. and Mehta, P., 2000. Globalization and International Public Fi-
nance (Working Paper No. 7575, NBER).
Paasche, B. and Zin, S., 2001. "Competition and Intervention in Sovereign Debt
Markets", NBER Working Papers No. 8679.
Pasricha, K., 2010. "Bank Competition and International Financial Integration:
Evidence Using a New Index," Working Papers 10-35, Bank of Canada.
Rajan, Raghuram G. & Zingales, Luigi, 2003. "The great reversals: the poli-
tics of nancial development in the twentieth century," Journal of Financial Economics,
Elsevier, vol. 69(1), pages 5-50, July.
Rappoport, V., 2010. Trade-o Between International and Domestic Risk Sharing
in the Presence of Sovereign Risk (Manuscript)
Appendix
26
A. Case studies on competition in the nancial sector and cap-
ital ow liberalization
As an illustration, I discuss two cases of nancial reform of countries with similar
levels of deposits and credit, prior to nancial liberalization. Looking at Figure 4 it is
possible to see two dierent approaches to nancial reform. India took the approach
suggested by the model presented in Section 3. It opened up to capital ows gradually,
but kept some restrictions to competition in its nancial sector. The outcome was slow
but steady growth in deposits and in credit. On the other hand, Indonesia liberalized
domestic nancial competition more and together with capital ow liberalization. As a
result it experienced faster growth, albeit with a famous crisis in the late 1990s, leading
to a reversal in nancial reform. Although arguing that this crisis was an enforcement
crisis as the one studied in Section 3 would require signicantly more data, I believe that
these patterns are illustrative of the mechanisms studied in this paper.
0
.
5
1
1973 1981 1989 1997 2005
Year
BANK DEPOSITS / GDP PRIVATE CREDIT / GDP
Financial Reform Index (normalized), 0 to 1
India
0
1
2
3
1970 1980 1990 2000 2010
Year
International capital flows Entry barriers/pro-competition measures
India
0
.
5
1
1973 1981 1989 1997 2005
Year
BANK DEPOSITS / GDP PRIVATE CREDIT / GDP
Financial Reform Index (normalized), 0 to 1
Indonesia
0
1
2
3
1970 1980 1990 2000 2010
Year
International capital flows Entry barriers/pro-competition measures
Indonesia
Figure 4: The left panels plot Deposits/GDP, Credit/GDP and the index for nancial reform
for India and Indonesia. The right panels decompose two categories that enter this index:
restrictions to international capital ows and to domestic competition (3 = fully liberalized).
B. Correlation matrix
27
cred intr intl entr regl priv sec
cred 1
intr 0.5916 1
intl 0.5607 0.5992 1
entr 0.5123 0.5078 0.4816 1
regl 0.6 0.5248 0.5621 0.5149 1
priv 0.4863 0.4534 0.5362 0.4335 0.4786 1
sec 0.5757 0.5775 0.6915 0.5091 0.6119 0.482 1
C. Additional empirical results
Macro reforms lead micro reforms
A simple test of whether macro reforms lead micro reforms is to perform a Granger
causality test of the panel of reform. To this eect, I run the following regressions:
:ic:o
t
= ,
0
+ ,
1
:ic:o
t1
+ ,
2
:cc:o
t1
+ n
t
:cc:o
t
= c
0
+ c
1
:ic:o
t1
+ c
2
:cc:o
t1
+
t
(39)
I control for year and country xed eects. The null hypothesis for the experiment I
am considering is that ,
2
= 0. That is, that past levels of the macro index do not help
to explain current levels of the micro index. Furthermore, even if the data rejects that
,
2
= 0, it should be the case that it does not reject that c
1
= 0, meaning that macro
indices granger causes micro indices but not the other way around. Note that these indices
are stationary by construction. They are bounded above by 3 and bounded below by 0 .
Still, given that there is a reform process in place, the data may appear non-stationary in
the sample. To avoid concerns about stationarity, I perform the regressions in (39) also
in rst dierences, where I remove country xed eects.
:ic:o
t
= ,
0
+ ,
1
:ic:o
t1
+ ,
2
:cc:o
t1
+ n
t
:cc:o
t
= c
0
+ c
1
:ic:o
t1
+ c
2
:cc:o
t1
+
t
(40)
Table presents the results. It is possible to see that it is possible to reject that ,
2
= 0
and it is not possible to reject that c
1
= 0.
Table 10 Year FE + Country FE Year FE
Levels (39) Changes (40)
micro(t) macro(t) dmicro(t) dmacro(t)
micro(t-1) 0.778*** -0.0456
(0.0347) (0.0539)
macro(t-1) 0.0724*** 0.825***
(0.0190) (0.0302)
dmicro(t-1) 0.0671* 0.0325
(0.0379) (0.0684)
dmacro(t-1) 0.0794*** 0.0391
(0.0268) (0.0334)
Constant 0.505*** 0.844*** 0.00860 0.0300
Obs 782 782 748 748
R-squared 0.974 0.927 0.124 0.047
28
Growth regressions
In this subsection, I take the approach of Bekaert et al (2005) and estimate the eect
of nancial reform on growth. The main results are that using the graded index by Abiad
et al (2010), I can reproduce the growth eect of equity market liberalizations. I then
proceed to study the eect of macro vs. micro reforms, and their sequencing.
I replicate Table 4 in Bekaert et al (2005) using an extended time sample (1980-2005)
and a graded index instead of a dummy. The regression is given by:

i;t+k;t
= ,Q
i;1980
+
0
A
i;t
+ c
0
1i/
i;t
+
i;t+k;k
(41)
Where
i;t+k;t
are the average growth over non-consecutive 5 year windows. Q
i;1980
represents G11 per capita in 1980, and the other controls (A
i;t
) include government
spending as a percentage of G11, proportion of secondary school enrollment, population
growth and life expectancy. I follow Bekaert et al (2005) and perform a pooled OLS
regression where I test the impact of dierent nancial reforms (1i/). Table 2 suggests
that increasing the equity market index by one unit increases average growth by 0.6%.
25
This eect is still presenting when controlling for current account liberalizations.
Table 11
(1) (2) (3) (4) (5) (6) (7) (8)
EM 0.0041** 0.0082*** 0.00588*** 0.00555** 0.00209 0.00173 0.00636*** 0.00628**
(0.00166) (0.00220) (0.00180) (0.00243) (0.00183) (0.00218) (0.00230) (0.00265)
l80 -0.0055*** -0.0137*** -0.0137***
GGDP -0.0009** -0.00025 -0.00025
2ndy -0.00652 -0.0128 -0.0129
PopGr -0.374** -0.479*** -0.478***
log(life) 0.0278 0.108*** 0.108***
CA 0.00013
(0.0023)
Cons 0.0125*** 0.0523*** 0.0222*** 0.0147*** 0.0215*** -0.101 -0.31*** -0.31***
Obs 256 256 256 256 256 256 256 256
AdjR2 0.0189 0.0455 0.0387 0.0179 0.0378 0.0255 0.159 0.156
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Table 3 performs the same regression as described in (41) on dierent dimensions of
reform.
25
Here I am assuming that the eect is linear. An alternative specication with a full set of dummy
variables for the alternative entries of this index 0, 1, 2, 3 yields similar results.
29
Table 12 Univariate Regressions Univariate Regressions Multivariate Regressions
(1) - (7) (8) - (14) (15) (16)
Capital Account 0.00285* 0.00280 -0.000146 -0.00133
(0.00170) (0.00202) (0.00260) (0.00242)
Credit Controls 0.00560*** 0.00633*** 0.00504** 0.00446**
(0.00173) (0.00180) (0.00227) (0.00208)
Interest Rate Controls 0.000512 -1.75e-05 -0.00375* -0.00419**
(0.00168) (0.00185) (0.00219) (0.00206)
Equity Market 0.00405** 0.00636*** 0.00228 0.00455*
(0.00166) (0.00230) (0.00259) (0.00268)
Entry Barriers 0.000916 0.00148 -0.00321 -0.00219
(0.00166) (0.00175) (0.00213) (0.00196)
Regulation 0.00615*** 0.00825*** 0.00544** 0.00572**
(0.00177) (0.00203) (0.00256) (0.00240)
Privatization 0.00197 0.00436*** -3.62e-05 0.00299*
(0.00150) (0.00153) (0.00185) (0.00177)
log1980 No Yes -0.0139***
GovGDP No Yes -0.000489
Secondary No Yes -0.0156
PopGr No Yes -0.476***
Log(life) No Yes 0.114***
Cons 0.0162*** -0.328***
Observations 256 256
Adj R2 0.0552 0.211
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
The rst column reports regressions (1)-(7). These are univariate regressions of the
each of the index entries on average growth. Column 8 regresses all the elements of the
index separately. Unsurprisingly, there is some evidence of collinearity between dierent
dimensions of the index. Capital account, interest rate controls and entry barriers all
have sign changes.
26
Table 4 performs the growth regression on micro and macro nancial
reforms. It is possible to see that microreforms are crucial for growth, and that the eect
is larger than just looking at equity market liberalizations in the spirit of Bekaert et
al (2005).
27
The coecient of micro reforms is dierent from the coecient for macro
reforms at the 10% level.
26
Further work is needed to disentangle the eects of dierent dimensions. Appendix C presents the
correlation matrix between these variables.
27
The coecient of equity market reforms in this data is 0.00636. The coecient for the micro index
is 0.00932.
30
Table 13 (1) (2) (3)
Micro Index 0.00932*** 0.0101***
(0.00258) (0.00355)
Macro Index 0.00674*** 0.00164
(0.00244) (0.00325)
log1980 -0.0147*** -0.0139*** -0.0147***
GovGDP -0.000182 -6.81e-05 -0.000203
Secondary -0.0169 -0.0103 -0.0167
PopGr -0.512*** -0.465*** -0.518***
Log(life) 0.122*** 0.115*** 0.123***
Cons -0.362*** -0.345*** -0.363***
Obs 256 256 256
Adj R2 0.177 0.150 0.174
Standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1
Table 5 introduces dummy variables that take a value of 1 depending on the sequencing
of reform. The omitted variable corresponds to a situation of status quo. The dummy
variable identifying periods where a macro reform took place but a micro reform did not
is negative and highly signicant. Column (1) does the analysis for the full sample, while
column (2) focus on developing economies. The eect is stronger in the latter group.
A potential omitted variable problem remains. In a balance of payments crisis, an IMF
based reform may not maximize growth opportunities. In particular, it can be tilted
towards macro reforms. If that is the case, the dummy variable capturing leading macro
reforms is in fact capturing the recession during a balance of payments crisis. Current
research is addressing this issue by introducing information on balance of payments crisis
and on the content of IMF programs.
28
28
A description of IMF based reforms is an interesting project in its own right.
31