Information about Asia and the Pacific Asia y el Pacífico
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3 Trade and Financial Openness

Author(s):
Catriona Purfield, and Jerald Schiff
Published Date:
August 2006
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Information about Asia and the Pacific Asia y el Pacífico
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Author(s)
Renu Kohli and Michael Wattleworth 

The Indian economy has become increasingly open over the course of the past two decades. The combined share of imports and exports in the Indian economy has doubled over the past 20 years to reach about 35 percent of GDP in 2005. Capital flows have also been on the rise—in 2005, India was the top destination in Asia for private equity funds. Most observers attribute the rise in trade and capital flows to the liberalization of the economy, particularly the reduction of trade tariffs and capital controls. This process began in the 1980s but gathered steam following the 1991 balance of payments crisis and continues today. Despite these changes, however, India still accounts for a small share of world trade in goods and services: only 1½ percent in 2005 compared, for example, to China’s 6¼ percent. Its net capital inflows of 3 percent of GDP are also still small in a regional context.

The fact that India has still to make significant inroads into global trade and financial markets only serves to underscore the substantial potential for greater openness to boost growth. Both trade reforms and capital account liberalization are ongoing, and continued opening to global markets will have important benefits for India. Moreover, these two pillars of increased openness have been, and will likely continue to be, mutually reinforcing. This chapter examines more closely the linkages between trade and financial openness in India. It first reviews the international literature, which emphasizes the positive effects that financial integration can have on trade. Next, it describes the key reforms in the areas of trade and capital account liberalization in India, highlighting how they have moved in tandem over the past two decades, and explores the potential linkages between the two processes. The following section conducts a more rigorous empirical analysis of the linkages between trade and financial openness in India, and the final section concludes.

The Links Between Trade and Financial Openness

Various studies across a wide range of countries find close links between trade and financial openness. Aizenman and Noy (2004) find strong bidirectional effects between the two with almost 90 percent of the feedback running from financial openness to trade. Chowdhury (2005) similarly finds financial openness to be an important driver of trade in goods and services in European countries and members of the Commonwealth of Independent States. Rose and Spiegel (2004) show that trade positively influences bilateral lending patterns, while Lane and Milesi-Ferretti (2004) demonstrate a similar positive correlation between bilateral equity holdings and trade in goods and services.

Why are financial and trade openness mutually reinforcing? The literature explores various potential reasons.

  • Foreign investment. This is likely a key channel by which greater financial openness can affect trade. Aizenman and Noy (2005) find a two-way relationship between foreign direct investment (FDI) and trade flows, particularly in manufacturing. Swenson (2004) identifies the import stimulating effects of FDI in manufacturing for investments by member countries of the Organization for Economic Cooperation and Development (OECD) in the United States, with multinational companies importing intermediate inputs from their home country. Hanson, Mataloni, and Slaughter (2001) provide evidence that vertical FDI—defined as exports from affiliates of multinational firms to the home country—also generates higher exports of final products.
  • Reductions in the cost of capital. Financial openness can help overcome liquidity constraints, enabling countries to specialize and exploit economies of scale, thereby raising their ability to compete internationally.1 Moreover, the availability of trade credit can promote trade. Beck (2002) finds that financial depth (an outcome of financial openness) is associated with higher manufacturing exports and an improved trade balance in manufactured goods in a study of 65 countries over a 30-year period.
  • Demand-side effects. Trade increases manufacturers’ exposure to fluctuations in external demand, increasing the demand for hedging instruments and/or access to external finance to help buffer these shocks. Greater trade openness can also make it harder to sustain restrictions on capital flows by providing more channels for capital flight. Svaleryd and Vlachos (2002) find that the degree of integration in international financial markets has an independent effect on openness to trade. In low-income countries, Huang and Temple (2005) note that increased goods trade typically is followed by a sustained increase in financial development.
  • Supply-side effects. A rise in international trade in financial assets will encourage trade openness through increased risk sharing and specialization in production (Kalemli-Ozcan, Sorensen, and Yosha, 2003). Imbs (2003) shows that specialization patterns reflect openness to trade in goods and assets. Rajan and Zingales (2003) attribute the association between commercial and financial openness to political economy factors. The liberalization of cross-border trade and capital flows weaken entrenched interests of those opposed to financial development leading to a positive correlation between the two types of openness. The empirical literature on financial development and trade also finds evidence that financial and trade openness encourages financial development, which, in turn, boosts growth.2 The growth effects of trade and financial openness increase with the level of development but taper off at higher levels of income,3 while higher levels of financial development can facilitate greater exports.4

Trade and Financial Liberalization in India

The process of trade liberalization in India began in the early 1980s, but gained momentum following the 1991 balance of payments crisis. The peak tariff rate on nonagricultural goods has fallen progressively from 150 percent in 1991/92 to 12½ percent in 2006 and the share of customs revenue in GDP—about 1.8 percent of GDP in 2005/06—has halved. Nontariff barriers were also eased with licensing restrictions on raw materials and intermediate and capital goods eliminated in 1991 and a tariff line-wise import policy introduced in 1996. As a result, the share of unrestricted import products in total imports has increased to more than 95 percent from under two-thirds in 1996 and the proportion of “canalized”5 items in total imports declined from 27 percent to 19 percent between 1988/89 and 1997/98.6 The impact of these reforms has been mostly positive (Box 3.1).

Box 3.1.Empirical Evidence on Trade Liberalization

Empirical assessments of trade liberalization have shown the benefits of trade reforms on productivity growth and the current account, but the impact on poverty and income inequality is unclear. Trade indicators have strengthened since the 1980s, with manufacturing exports growing significantly (see table).

Manufacturing and Total Trade Indicators, 1980–2003
Manufacturing ExportsServices ExportsManufacturing ImportsManufacturing Trade
Exports to GDPImports to GDP(In percent of GDP)(In percent of GDP)(In percent of GDP)Total Trade to GDP(In percent of GDP)
1980s4.46.82.61.43.611.26.3
1990s7.58.95.62.14.616.410.2
2000–039.311.17.04.55.720.412.7
Sources: IMF, Balance of Payments Statistics; World Bank, World Development Indicators; and IMF staff calculations.
Sources: IMF, Balance of Payments Statistics; World Bank, World Development Indicators; and IMF staff calculations.

At the firm level, trade liberalization has been particularly beneficial to total factor productivity growth in industries close to the technological frontier (Aghion and others, 2003; Siddharthan and Lal, 2004), firms located in regions or sectors with a more flexible labor environment, and those that were privately managed (Topalova, 2004a). However, the impact on poverty and income inequality remains inconclusive (Topalova, 2004b; Mishra and Kumar, 2005).

The effect of trade reforms on macroeconomic variables has also been positive. Most studies conclude that trade liberalization resulted in a trade surplus in intermediate and capital goods, rising imports and exports (Goldar, 2002; Virmani and others, 2004), increased intra-industry trade (Veeramani, 2004), and greater diversity and resilience in the balance of payments (Virmani, 2003). As a result of the reductions in trade protection since the early 1990s, economic growth accelerated at both the national and state levels (Ahluwalia, 2000, 2002).

In parallel, the government began to gradually relax controls on capital inflows, particularly direct and portfolio investments from the early 1990s (Box 3.2). A relatively well-developed equity market facilitated these reforms. Reforms initiated between 1991 and 1997 aimed to increase the extent of foreign investor participation in the stock market while expanding the range of sectors open to FDI. Quantitative ceilings on foreign investment through the stock exchange were steadily raised and the domestic debt market was opened to some limited foreign investment in 1997. At the same time, the government also made it easier for resident corporates to tap international financial markets, while keeping controls on resident individuals in place. Initially, access to foreign commercial borrowings by corporates was confined to infrastructure, core (industries that produce primary products as raw material inputs for other firms), and export-oriented industries, but was subsequently extended to other manufacturing firms. However, throughout the capital account liberalization process, controls have been maintained on the maturity and end-use of external borrowings, and the flow of funds into India have been controlled via quantitative ceilings to keep external debt indicators at sustainable levels thereby safeguarding India’s vulnerability to external shocks.

These reforms were successful in raising India’s openness to trade and financial flows (Figure 3.1).7 The share of exports in GDP jumped from 6.2 percent in the 1980s to 15.1 percent of GDP during 2000–05. Import shares also climbed from 8.9 percent of GDP to 17.1 percent of GDP over the same period. The pace of import growth accelerated in the 1990s and the structure of imports moved toward technology-intensive and export-oriented products, with capital and intermediate goods emerging as principal import items. (Chapter 4 also shows that Indian exports have made inroads into new markets and have broadened into the high-growth areas of iron and steel, petroleum, and pharmaceutical products.) Financial flows have multiplied, driven mainly by a surge in portfolio inflows and external commercial borrowings. Nevertheless, as Figure 3.2 shows, India still ranks low on measures of trade and financial openness compared with other emerging market economies.

Figure 3.1.Trade and Financial Openness

(In percent of GDP)

Sources: Lane and Milesi-Ferretti database on capital stocks and flows; and IMF, International Financial Statistics.

Figure 3.2.India’s Financial and Trade Openness in International Perspective, 2003

Sources: Lane and Milesi-Ferretti database on capital stocks and flows; and IMF, International Financial Statistics.

Trade and financial openness appear to be complementary both over time and across countries. Measures of trade and financial openness in India are positively correlated over the 1970–2003 period and the correlation appears stronger in the post-1991 liberalization period (Figure 3.3). Gross financial flows also display a strong and positive correlation with the current account balance (net flows) in the postreform period and a bivariate regression of the change in trade and financial openness constitutes further evidence of the positive relationship between the two.

Figure 3.3.Correlation of Financial and Trade Openness: Financial Openness and the Current Account

(Five-year averages)

Sources: Lane and Milesi-Ferretti database on capital stocks and flows; and IMF, International Financial Statistics.

One channel through which financial liberalization may have contributed to greater trade in India is through the cost of capital. Table 3.1 shows that the cost of external capital declined sharply over the course of the 1990s, and the fact that the share of private debt in total external debt rose from 40 percent in 1995 to over 60 percent in 2004 appears to confirm that domestic firms were taking advantage of their enhanced freedom to borrow abroad. The liberalization of foreign equity inflows will also have augmented the supply of equity finance and lowered domestic borrowing costs.

Table 3.1.Domestic and Foreign Borrowing Costs, 1981–2003
Nominal Lending RatesCPI InflationReal Lending RatesOne-Year LIBORExchange Rate (Percent change)Effective Cost of Foreign Loans
(1)(2)(1 – 2)(3)(4)(3 + 4)
198116.513.13.416.110.226.3
198516.55.511.09.18.918.0
199116.513.92.66.329.936.2
199219.011.87.24.214.018.2
199319.06.412.63.617.621.3
199415.010.24.85.62.98.5
199516.510.26.36.23.49.6
199614.59.05.55.89.315.0
199714.07.26.86.12.58.6
199814.013.20.85.513.619.2
199912.04.77.35.74.410.1
200011.54.07.56.84.411.2
200111.53.77.83.95.08.9
200210.84.46.42.23.05.2
200310.33.86.41.4−4.2−2.8
Sources: Reserve Bank of India, Handbook of Statistics; IMF, International Financial Statistics; and IMF staff calculations.
Sources: Reserve Bank of India, Handbook of Statistics; IMF, International Financial Statistics; and IMF staff calculations.

FDI has not historically been a major driver of India’s growing openness, in contrast to many Asian countries, but it is increasingly becoming so. FDI inflows to India have been comparatively low (see Chapter 5) and initial FDI inflows were concentrated in areas such as domestic appliances, food and dairy products, and financial sectors that sought to tap India’s large domestic market rather than establish export potential. The notable exception was the information technology (IT) sector, which was identified as a thrust area for foreign investment in the early stages of liberalization.8 In recent years, however, FDI inflows and export growth in manufacturing sectors such as chemicals, electronics, and engineering as well as services have accelerated (Figure 3.4). Moreover, the indirect effects of FDI—including technological and skill advancement, spillovers, and related externalities—are clearly visible in India.

Figure 3.4.Exports by Sector

(In millions of U.S. dollars)

Sources: Reserve Bank of India, Handbook of Statistics.

Foreign investment is beginning to emerge as an important channel through which financial openness has an impact on trade. The bulk of FDI inflows have gone to the export-oriented sectors, which registered strong growth over the 1990s. Between 1992/93 and 2001/02 the chemical and allied products (12 percent), engineering goods (21 percent), electronics and electrical sector (9 percent), and the services sector (9 percent) accounted for the bulk of cumulative FDI inflows. IT services, the original beneficiary of many of the investment inflows, have also grown exponentially with their share of total exports rising to 21 percent in 2003/04 from a mere 3 percent in 1996/97. Openness to FDI inflows and outflows appears to have stimulated trade via increased imports, including imports of intermediate inputs from the home country by multinational firms. Indeed, correlations of subcomponents of financial flows and trade (Table 3.2) suggest that the removal of direct restrictions on foreign investment has been associated with a rise in trade. Most of this association is due to an association between manufacturing imports and FDI, with the FDI openness-exports link also positive, but less strong. Other capital flows, such as portfolio inflows and loans, are not as strongly associated with trade, with correlations that are weak or even negative.9 The following section explores these linkages more formally, particularly the role of FDI in promoting greater trade openness.

Table 3.2.Correlations Between Decomposed Financial and Trade Flows, 1991–20031
Trade Openness in GoodsTrade Openness in ServicesManufacturing Trade OpennessManufacturing Exports (Share in GDP)Manufacturing Imports (Share in GDP)
FDI openness (sum of FDI inflows and outflows/GDP)0.85*0.82*0.87*0.43*0.75*
Portfolio openness (sum of portfolio inflows and outflows/GDP)0.350.090.26*0.020.05
Loans openness (sum of loans assets and liabilities/GDP)−0.29*−0.14*−0.2*0.25*−0.44*
Sources: IMF, Balance of Payments Statistics; and IMF staff calculations.

Sample restricted to 1991–2003 as the subcategories, FDI and portfolio, only start from 1991, after liberalization. * indicates significant at the 10 percent level.

Sources: IMF, Balance of Payments Statistics; and IMF staff calculations.

Sample restricted to 1991–2003 as the subcategories, FDI and portfolio, only start from 1991, after liberalization. * indicates significant at the 10 percent level.

Box 3.2.Capital Account Liberalization

Among the key steps to liberalize the capital account since the early 1990s are the following:

Inflows

Foreign direct investment (FDI). Initial liberalization of FDI inflows saw investment limits in new and existing industrial companies raised from 40 percent to 51 percent of paid-up capital, and up to 74 percent in specific industries. The technology transfer requirement was removed and the scope of FDI expanded beyond export-oriented, import-substituting industries. FDI was initially subject to approval, but the list of industries automatically approved has progressively widened so that by 2000 almost all industries were under the automatic route. (Under the automatic route, prior approval is not required; only the reporting stipulations have to be met.) In January 2004, FDI limits in several sectors, including banking and petroleum and natural gas, were raised.

Portfolio investment. Foreign institutional investors (Flls) were first allowed to make portfolio investments in the equity market in 1993. In 1997, FIIs were allowed to invest in the Indian debt market subject to specific ceilings that have been progressively relaxed, although they remain low.

External borrowing. India’s policy on external commercial borrowings (ECBs) has been dictated by the need to keep external debt at sustainable levels. As a result, controls on ECBs have limited the cost, quantity, maturity, and end-use of these inflows. Controls have been progressively relaxed. Domestic borrowers operating in the infrastructure, export, and manufacturing sectors are permitted to access international financial markets. However, long-term borrowings are favored over short-term borrowings and ECBs beyond specific ceilings require approval from the Reserve Bank of India (RBI).

Nonresident deposits. India permits nonresidents to hold deposits. However, the interest rates paid on these deposits are subject to specific ceilings that are linked to international rates.

Outflows

India’s approach to the liberalization of capital outflows has been one of facilitating direct overseas investments by Indian corporates while keeping the capital account largely closed for resident individuals. Overseas investments are recognized as an important avenue for expanding Indian businesses. Accordingly, rules and procedures related to these have been liberalized significantly. Resident corporates and partnership firms can invest up to 200 percent of their net worth in overseas joint ventures or wholly owned subsidiaries. Exporters and exchange dealers are allowed to maintain foreign currency accounts and to use them for their overseas businesses. Individuals were generally unable to transfer funds from India without RBI approval until 2004 when residents were permitted to take $25,000 abroad a year without prior approval. The ability of Indian mutual funds to invest abroad has also been enhanced; in 2006, the quantitative ceiling on such investments has been revised, and the types of eligible investments broadened.

Econometric Analysis

To test the link between financial openness and trade more formally we estimate a simple econometric model. The change in trade is modeled as a function of the one- and two-period lagged values of the change in financial openness and a set of conditioning macroeconomic explanatory variables. The latter include per capita income growth (pcy), the gross fiscal deficit to GDP ratio (percent), the log of the change in the real exchange rate index (qt), and the domestic and the foreign rates of interest, i and i*. A dummy for the post-1991 period is also included to test whether relationships have changed since reform took off. The reverse specification, focusing on the impact of trade openness upon future financial openness, is also estimated. To minimize the risk of simultaneity bias the macroeconomic variables are also lagged. Tables 3.3 and 3.4 use annual 1970–2003 data to model the relationship, while Tables 3.5 and 3.6 use quarterly data from 1990 to 2004.10

The results reveal that changes in financial openness (ΔFO) have a positive and significant impact on trade openness (ΔTO).11 In terms of magnitudes, specification 1 of Table 3.3 indicates that a 10 percent increase in financial openness is associated with a 2.1 percent increase in trade openness two years later, a finding that is robust to the exclusion of the post-1991 liberalization dummy. Since financial openness proxies as a measure of capital account openness, our results suggest that the easing of capital controls in India has had a positive effect by encouraging trade, although at this level of aggregation, it is difficult to establish the exact channel of influence. However, the coefficient on financial openness is significantly lower than that estimated by Aizenman and Noy (2004) who, using panel data from a sample of developing economies, find a coefficient of 0.43. This suggests that the impact of lagged financial openness on contemporary trade openness in India may be below the developing country average. With respect to the macroeconomic controls included in specification 2, an increase in per capita GDP, a real exchange rate depreciation, and declining domestic or global interest rates as well as a smaller budget deficit are expected to increase trade openness. All these variables enter the expanded regression in specification 2 with the expected sign, and all are significant with the exception of per capita GDP growth.

Table 3.3.OLS Estimates: Impact of Financial Openness on Trade Openness, 1970–20031(Annual)
ΔTOtΔTOt
12
ΔFOt-1-0.073−0.011
1.110.22
ΔFOt-20.210.18
4.37***2.22***
pcyt-10.0002

0.20
Δqt-1-0.08

1.78**
Grossfiscaldeficitt-1−0.002

1.63*
it-1−0.002

2.44***
i*t-1-0.0009

2.23**
πt-10.001

1.76**
Liberalization dummy0.009

2.51***
Adj R20.240.40
DW1.992.36
ρ−0.55***−0.57**
No. of observations2424
Source: Authors’ calculations.

All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroske-dasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

Source: Authors’ calculations.

All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroske-dasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

The results also show that a change in trade openness has a positive and significant impact on financial openness. A unit increase in trade openness is found to lead to a 4–6 percent increase in financial openness two years later (Table 3.4).12 including macroeconomic control variables in specification 2—per capita GDP growth, a positive interest rate differential, a real exchange rate appreciation, and higher fiscal deficits—makes the coefficient on financial openness stronger.13 While the coefficient on budget deficit/GDP ratio suggests a significant influence of increased government expenditure on financial openness, the insignificant impact of real exchange rate changes is puzzling. This regression, however, is sensitive to the 1995 outlier which reflects a sharp drop in net portfolio inflows in that year (Table 3.4).

Table 3.4.OLS Estimates: Impact of Trade Openness on Financial Openness, 1970–20031(Annual)
ΔFOtΔFOt
12
ΔTOt-1−0.34−0.11
1.81*1.19
ΔTOt-20.460.63
1.87*3.52***
pcyt-10.0005

0.22
Δqt-10.02

0.44
Grossfiscaldeficitt-10.004

1.60*
(ii*)t-10.002

3.68***
Adj R20.460.72
DW1.622.49
ρ−0.62***
No. of observations2424
Source: Authors’ calculations.

Regressions 1 and 2 control for an influential outlier in 1995, the coefficient values of which are -0.09*** and 0.11*** . All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroskedasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

Source: Authors’ calculations.

Regressions 1 and 2 control for an influential outlier in 1995, the coefficient values of which are -0.09*** and 0.11*** . All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroskedasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

One drawback of using aggregated trade and capital flow data in this type of analysis is that it does not yield any information about which trade and financial flows are related. We, therefore, exploit the information from the quarterly balance of payments statistics to examine this issue. Table 3.5 expresses the change in total trade openness (ΔTO) as a function of total FDI openness (ΔFdiopenness), total portfolio equity openness (ΔPortfolioopenness), and total loans openness (ALoansopenness).14Table 3.6 simply replaces the right-hand-side variables with financial openness now defined as openness to FDI inflows (ΔFdiinopenness), portfolio inflows (ΔPiiopenness), and inward loans (ΔLiopenness).15 We began with a general lag structure that included up to eight lags and progressively removed insignificant lags to arrive at a parsimonious specification.

Table 3.5.Impact of FDI, Portfolio, and Loan Openness on Trade Openness1(Goods, services, and business services, 1990:1–2004:1)
Dependent variableΔTOGtΔTOStΔTOBSt
Explanatory variables123
ΔFdiopennesst-30.11***

4.59
0.22***

3.12
ΔFdiopennesst-40.06***

3.05
ΔPortfolioopennesst-2−0.017**

1.88
−0.001

0.06
ΔPortfolioopennesst-3−0.012**

1.85
ΔLoansopennesst-30.05***

3.54
0.10***

2.80
ΔLoansopennesst-40.012

1.23
Δqt-1-0.008**

2.26
Δqt-2−0.008***

2.47
−0.04***

2.69
i*t-10.04***

3.30
i*t-5-0.012**

2.01
−0.015

1.01
Adj R20.220.400.26
DW1.921.942.06
ρ−0.51***−0.57***−0.46***
No. of observations424848
Source: Authors’ calculations.

All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroskedasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

Source: Authors’ calculations.

All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroskedasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

FDI flows are found to boost trade in both the goods and services sectors (Table 3.5). The coefficients indicate that a percentage point rise in openness to FDI increases trade in goods (ΔTOGt) by 0.6 percent and trade in services (ΔTOSt) by 1 percent with about a one-year lag. Using business services trade (ΔTOBSt) in lieu of overall services reveals an even larger response of 2.4 percent. However, openness to portfolio flows is associated with a reduction in trade in goods (-0.007) and services (-0.017). The impact on business services is insignificant. Replacing net portfolio flows with portfolio inflows in Table 3.5 does not alter this finding.

Table 3.6.Impact of FDI, Portfolio, and Loan Inflows Openness on Trade Openness1(Goods, services, and business services, 1990:1–2004:1)
Dependent variableΔTOGtΔTOStΔTOBSt
Explanatory variables
ΔFdiinopennesst-30.11***

5.07
0.24***

3.72
ΔFdiinopennesst-40.06***

3.45
ΔPiiopennesst-22−0.007*−0.017**0.0005
1.691.950.004
ΔLiopennesst-320.02*0.05***0.11**
1.693.582.92
Δqt-1-0.002

0.73
Δqt-2−0.009***

3.33
−0.04***

2.82
i*t-10.03***

2.80
i*t-5-0.012***

2.73
−0.016

1.06
Adj R20.160.420.28
DW1.971.942.06
ρ−0.32*−0.58***−0.47***
No. of observations474848
Source: Authors’ calculations.

All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroske-dasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

ΔPiiopennesst-2 and ΔLiopennesst-3 denote portfolio and loan inflows openness, respectively (see the Appendix).

Source: Authors’ calculations.

All regressions assume an AR(1) process, p is the coefficient term. OLS specification with heteroske-dasticity-consistent errors. ***, **, and * indicate 1 percent, 5 percent, and 10 percent significance levels, respectively.

ΔPiiopennesst-2 and ΔLiopennesst-3 denote portfolio and loan inflows openness, respectively (see the Appendix).

Increased access to external financing also boosts trade. A percentage point rise in external borrowings has a positive impact on trade openness in services (0.5 percent). The impact of access to external loans on business services trade is twice as strong, while the impact on trade in goods is insignificant. But when aggregate loans are replaced with loan inflows in Table 3.6, the impact on goods trade becomes significant, but remains much smaller than the impact on services trade. These results suggest that increased access to external commercial borrowings as part of the capital account liberalization process has facilitated trade in goods and services by reducing the cost of capital. The differential impact of various types of financial openness highlights the productive links of FDI and loans with trade. The exception is equity flows that are more equally dispersed across domestic and external sectors and are associated with a reduction in trade openness.

Conclusions

The main contribution of this chapter is to use time-series data to examine the impact of financial openness on trade openness. The chapter finds a significant mutual impact of the two kinds of openness. Although the impact of trade openness on financial openness is not very surprising, the role of financial integration in driving trade openness is striking. FDI is found to be strongly associated with increased trade in both goods and services, suggesting that further liberalization of FDI could increase India’s trade potential.

Financial liberalization stimulated trade through the foreign investment and the cost of credit channels. The findings of this chapter also provide evidence on the benefits from capital account liberalization. Restrictions on external capital account transactions can operate as both direct or indirect restrictions on trade development, and the removal or gradual elimination of these controls can help boost India’s role as a global player. The results suggest that trade openness should be complemented with financial sector reforms to increase the gains from trade liberalization. The mutual impact of both kinds of openness also contributes toward building a consensus for trade and financial sector reforms.

Appendix. Data Sources and Definitions
Variable NameDefinition/Construction of VariableSource
Trade opennessSum of exports and imports as share of GDP.IMF, International Financial Statistics (IFS).
Financial opennessThis measure calculates gross levels of foreign direct investment (FDI), portfolio, and other assets and liabilities via accumulation of corresponding inflows and outflows, with valuation adjustments. It is thus less volatile than flow measures of financial integration and less prone to measurement error.Lane and Milesi-Ferretti (2004).
FDI opennessSum of FDI inflows and outflows as share of GDP.IMF, IFS.
FDI inflow opennessFDI inflows as share of GDP.IMF, IFS.
Portfolio opennessSum of portfolio inflows and outflows as share of GDP.IMF, IFS.
Portfolio inflow opennessPortfolio inflows as share of GDP.IMF, IFS.
Loans opennessSum of loan inflows and outflows as share of GDP.IMF, IFS.
Loan inflow opennessLoan inflows as share of GDP.IMF, IFS.
Manufacturing tradeSum of manufacturing exports and manufacturing imports in percent of GDP.World Bank, World Development Indicators (WDI).
Manufacturing exportsManufacturing exports in percent of GDP.World Bank, WDI.
Manufacturing importsManufacturing imports in percent of GDP.World Bank, WDI.
External assistanceExternal aid.Reserve Bank of India (RBI), Handbook of Statistics.
Foreign investmentForeign investment.RBI, Handbook of Statistics.
Private loansCommercial borrowings.RBI, Handbook of Statistics.
Sectoral percentage shares in cumulative FDI inflowsSum of respective sectoral FDI inflows as percentage to total FDI inflows between 1992/93 and 2000/01.Report of the Committee on FDI, Planning Commission (2002).
Services, chemicals, and engineering exportsExports figures in millions of U.S. dollars.RBI, Handbook of Statistics.
Nominal lending ratePrime lending rateIMF, IFS.
pcyChange in log of real per capita income.World Bank, WDI.
GrossfiscaldeficitGross fiscal deficit as percentage of GDP.RBI, Handbook of Statistics.
ΔqChange in log of real per capita income.RBI, Handbook of Statistics.
(i – i*)Prime lending rate minus the six-month LIBOR.IMF, IFS.
πChange in the wholesale price index.IMF, IFS.
Liberalization dummyDummy taking value of 0 before 1991 and 1 thereafter.
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4Higher levels of financial development are also associated with an increase in exports; for example, exchange rate elasticities for exports are higher for countries with better finance (Becker and Greenberg, 2003).
5Goods that could only be imported via state-owned corporations.
6Quantitative restrictions are maintained on about 5 percent of tariff lines because of health, safety, moral conduct, and security reasons.
7The authors are grateful to Gian Maria Milesi-Ferretti for providing data on capital stocks and flows.
9The negative correlation might be due to the combining of loan transactions by government, the monetary authority, banks, and the private sector.
10The size of the sample is constrained by the availability of the Lane and Milesi-Ferretti financial openness measure. A summary description of the variables is given in the Appendix.
11Both variables are first-difference stationary processes. There was also at least one cointegrating relation between the two variables, suggesting a stationary linear combination of the two in one direction.
12A unit increase in trade openness in the past one period has the impact of significantly reducing contemporary financial openness by approximately 0.34, which is counterintuitive; a Wald test restricting the coefficient on this lag to be zero indicates that the restriction is statistically valid. The F-statistic is 3.28, indicating that the null hypothesis, ΔTOt-1 = 0 cannot be rejected.
13The finding is also robust to the inclusion of other variables such as the wholesale rate of inflation, and the exclusion of insignificant variables.
14Sum of each inflow and outflow as share of GDP. See the Appendix for description.
15FDI, portfolio, and loan inflows as share of GDP. See the Appendix for description.

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