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Economic theory has identified a number of channels through which openness to international financial flows could raise productivity growth. However, while there is a vast empirical literature analyzing the impact of financial openness on output growth, far less attention has been paid to its effects on productivity growth. We provide a comprehensive analysis of the relationship between financial openness and total factor productivity (TFP) growth using an extensive dataset that includes various measures of productivity and financial openness for a large sample of countries. We find that de jure capital account openness has a robust positive effect on TFP growth. The effect of de facto financial integration on TFP growth is less clear, but this masks an important and novel result. We find strong evidence that FDI and portfolio equity liabilities boost TFP growth while external debt is actually negatively correlated with TFP growth. The negative relationship between external debt liabilities and TFP growth is attenuated in economies with higher levels of financial development and better institutions.

A central debate in international finance is whether openness to foreign capital has significant growth benefits and whether, in the case of developing countries, these benefits outweigh the risks. In theory, there are a number of direct and indirect channels through which financial openness should increase economic growth. Yet there is little robust empirical evidence of a causal link between financial openness and economic growth. This is not for want of effort – a number of empirical studies have attempted to systematically examine whether financial openness contributes to growth using various approaches. The majority of these studies, however, tend to find no effect or at best a mixed effect for developing countries (see Kose et al., in press, for an extensive survey). The failure of most empirical studies to detect these presumed growth benefits has been used as ammunition by the critics of financial globalization who view unfettered capital flows as a serious impediment to global financial stability (e.g., Rodrik, 1998, Bhagwati, 1998 and Stiglitz, 2004). By contrast, proponents of financial globalization argue that increased openness to capital flows has, by and large, proven essential for countries aiming to upgrade from lower to middle income status, while also enhancing stability among industrialized countries (e.g., Fischer, 1998 and Summers, 2000). This is clearly a matter of considerable policy relevance, especially with major emerging market economies like China and India opening up their capital accounts and even a number of low-income countries experiencing large cross-border financial flows. This paper attempts to change the direction of this debate by focusing on the impact of financial openness on productivity growth, rather than output growth. Why does financial openness have the potential to enhance aggregate efficiency and, by extension, total factor productivity (TFP) growth? Recent studies suggest that there are many channels through which financial openness can have a positive impact on productivity growth. For example, Kose et al. (in press) identify a set of indirect benefits of financial openness and argue that these could have a positive impact on TFP growth because they lead to more efficient resource allocation (also see Mishkin, 2006). These indirect “collateral” benefits could include development of the domestic financial sector, improvements in institutions (defined broadly to include governance, the rule of law, etc.), better macroeconomic policies, etc., all of which could result in higher growth through gains in allocative efficiency. Moreover, an earlier literature has argued that certain types of capital flows such as foreign direct investment (FDI) can yield productivity gains in recipient countries directly through transfers of technology and managerial expertise. The nature of the relationship between financial openness and TFP growth has important welfare implications, especially in light of the recent literature emphasizing the role of TFP growth as the main driver of long-term per capita income growth. Although the earlier literature argued that factor accumulation is the key determinant of economic growth, a consensus is building that TFP growth is far more important than factor accumulation (Hall and Jones, 1999).1 In parallel to this shift in the broader growth literature, the classical notion that capital mobility allows capital-poor countries to grow faster by relaxing the constraints on domestic investment has also been challenged. Gourinchas and Jeanne (2006) argue that capital controls constitute only a transitory distortion since even a financially closed economy can eventually accumulate capital domestically and so the distortion vanishes over time. Hence, viewing the benefits of financial openness as being equivalent to a permanent reduction in this distortion may be an overstatement of the benefits. In other words, the direct welfare or growth gains from capital mobility are likely to be small. Instead, the theory implies that the benefits from financial openness should be reflected in TFP growth. In this paper, we provide a comprehensive analysis of the relationship between financial openness and productivity growth using an extensive dataset that includes various measures of productivity and financial openness for a large number of developed and developing countries. We distinguish between de jure capital account openness—the absence of restrictions on capital account transactions—and de facto financial integration, which we measure by stocks of foreign assets and liabilities relative to GDP. We find that economies with more open capital accounts generally have higher TFP growth. More importantly, our formal econometric analysis suggests that capital account openness has a causal effect on TFP growth even after controlling for the standard determinants of growth. This effect is robust to alternative regression specifications, the inclusion of a large set of control variables, and attempts to control for potential endogeneity. On the other hand, overall de facto financial integration does not seem to matter for TFP growth. However, this conclusion turns out to mask a novel and interesting result. When we disaggregate the financial integration measure into stocks of liabilities attributable to different types of underlying capital flows, we find strong evidence that FDI and portfolio equity boost TFP growth while debt is negatively correlated with GDP growth. The negative relationship between stocks of external debt liabilities and TFP growth is partially attenuated in economies with better-developed financial markets and better institutional quality. Our paper is closely related to Bonfiglioli (2008), which is the only other empirical macrostudy we are aware of that analyzes the impact of overall financial integration on TFP growth. Her findings, based on cross-country data over the period 1975–99, also suggest that financial integration has a positive direct effect on productivity growth. Our paper is complementary to hers in that we use a more comprehensive and updated dataset. More importantly, as noted above, we use a wide array of de jure and de facto financial openness measures to provide a number of additional important results on how the nature of financial integration and the composition of external liabilities influences TFP growth. This enables us to connect our results to an earlier literature focusing on the impact of specific types of capital flows on TFP growth. There is a strong presumption that FDI should yield productivity gains for domestic firms through several channels including imitation (adoption of new production methods), skill acquisition (education/training of labor force), and competition (efficient use of existing resources by domestic firms). Using cross-country data, Borensztein et al. (1998) conclude that FDI increases an economy's productive efficiency (also see de Mello, 1999 and Xu, 2000). There is a larger literature studying the productivity enhancing effects of FDI using firm- or sector-level data (see Haskell et al., 2007, and references therein). Javorcik (2004) and others find evidence that FDI raises productivity growth through vertical spillovers, which stem from the interactions between foreign firms and their local suppliers (backward linkages) and customers (forward linkages), rather than horizontal spillovers, which are associated with productivity spillovers from foreign firms to domestic firms in the same sector.2 There is also some work looking at the effects of equity market liberalizations on productivity growth. For instance, Henry and Sasson (2008) find that equity market liberalizations are associated with an increase in the growth rate of labor productivity in emerging market economies (also see Mitton, 2006). In the next section of the paper, we discuss the main features of our dataset and briefly review the mechanics of our growth accounting exercise. In Section 3, we present a set of stylized facts about the relationship between financial integration and TFP growth. In Section 4, we examine this relationship using various empirical methods and in Section 5 we subject our main results to a battery of robustness tests. We conclude with a brief summary of our findings and their implications in Section 6.

In this paper, we have provided a comprehensive empirical analysis of the relationship between financial openness and TFP growth. We find strong evidence that financial openness, as measured by de jure capital account openness, is associated with higher medium-term TFP growth. These results are robust to our attempts to deal with potential problems of endogeneity and reverse causality, leading us to the view that this may in fact be a causal relationship. But it is a subtle one. The level of de facto financial integration, as measured by the stock of external liabilities to GDP, is not correlated with TFP growth. But splitting up the stock of external liabilities reveals a novel and interesting result. FDI and equity inflows (cumulated over decade-long periods) contribute to TFP growth while debt inflows have the opposite effect. The negative effect of stocks of external debt liabilities on TFP is partially attenuated in economies with better-developed financial markets and better institutional quality. Why does financial openness—when measured by capital account openness or the stock of FDI and portfolio equity liabilities—have a significant positive effect on TFP growth, while the existing literature suggests that the effect of financial openness on output growth is not at all robust? (Obstfeld, 2008, highlights this conundrum). There are several possible reasons for this finding. First, the timing of the adjustment of TFP and output to greater financial integration may be different. TFP growth is often associated with the introduction of new technologies. If these are general-purpose technologies simultaneously affecting a number of sectors, they could result in an increase in the rate of obsolescence of both physical and human capital. This could potentially slow down the growth rate of output in the short run, offsetting the growth-enhancing effects of TFP (Aghion and Howitt, 1998). Second, financial openness might influence the reallocation of outputs and inputs across individual producers. By affecting the return to capital, financial openness could lead to changes in the entry and exit decisions of firms/plants. To the extent that this does not have a negative effect on net entry, aggregate factor productivity will increase because new plants are more productive than exiting plants.21 This reallocation from less productive to more productive plants would ultimately increase total factor productivity with no significant gains in employment. These productivity gains would increase over longer horizons since there could be additional gains from both learning and selection effects over longer periods. Third, there could be some adjustment costs that delay the realization of the positive effects of TFP on output growth in developing countries. As the adjustment of the capital stock to new technologies is completed, these effects are expected to disappear making the impact of financial openness on economic growth in the long run more visible. In light of the short history of the recent wave of financial globalization, which began in earnest only in the mid-1980s, perhaps it is easier to detect its positive effects on TFP growth than on output growth. The results in this paper point to a large and unfinished research agenda. One issue is to delineate more clearly the specific channels through which financial openness boosts productivity growth—these could include technological spillovers, higher efficiency due to increased competition, and improved corporate governance. A second issue is to investigate in more depth why de jure capital account openness delivers TFP growth benefits while de facto openness fails to do so. We have suggested some possible explanations but this issue remains to be conclusively resolved, especially since de facto openness seems to be more closely tied to GDP growth benefits than de jure openness. Another important issue is to understand better why some economies seem to attain larger productivity gains from financial openness. Our results suggest that this depends on the nature of financial flows and also on domestic financial and institutional development. Interestingly, even when we control for these domestic variables, the level of financial integration itself seems to make a difference – economies with higher levels of integration have higher marginal benefits from additional integration. There seem to be a variety of complex interactions among international financial integration and domestic financial sector development. Pursuing this issue in detail is beyond the scope of this paper and we leave it for future work. In summary, our analysis using macroeconomic data bolsters the microeconomic evidence (based on firm- or industry-level data) that financial integration, especially if it takes the form of FDI or portfolio equity flows, leads to significant gains in efficiency and TFP growth. Moreover, in tandem with the recent literature showing that TFP growth rather than factor accumulation is the key driver of long-term growth, our results suggest that—despite all the skepticism surrounding it and despite all of the potential costs and risks associated with it—capital account liberalization deserves another careful look.