Financial openness has been an important topic of discussion in the economics literature. One of the potential benefits of financial openness is its positive impact on productivity growth. The argument is that financial openness allows for greater access to capital, which can lead to increased investment, technological progress, and ultimately, higher productivity levels.
In this context, this post attempts to put a perspective on the arguments made by Prasad, Terrones, and Kose (2009) regarding the positive impact of financial openness on productivity growth, while also highlighting some additional considerations that should be taken into account when evaluating this relationship. Furthermore, this post also discusses the implications of the UK’s withdrawal from the European Union (Brexit) and its relation with the COVID-19 pandemic that happened in an adjacent period.
While I partially agree with Prasad, Terrones, and Kose (2009) regarding the positive impact of financial openness on productivity growth, I believe their arguments need further consideration. Specifically, at least four important points were not fully explored in their analysis and should be taken into account when evaluating their arguments.
The first point is that the effects of financial openness on productivity growth may differ across countries. Although theoretically, investments such as foreign direct investment (FDI) should continue until rates of return are equal, low-income and high-income countries have different levels of productivity. Therefore, the magnitude of financial openness’s impact on productivity growth may vary across countries. For instance, empirical evidence shows that productivity, particularly in terms of marginal product of capital, may not be much higher in low-income countries than in high-income countries.
The second point is that the authors did not consider social efficiency in their analysis. Social efficiency, which includes institutions, public policies, and cultural differences, is theoretically one of the main factors affecting financial integration (FDI) inflows. Empirical evidence shows that capital tends to flow to countries with better institutions. Therefore, social efficiency might contribute to explaining how financial openness bolsters productivity and the linkage between the two.
The third point concerns the importance of the risk premium in the analysis of financial openness. The risk premium can be a substantial cause of capital flow, particularly in emerging markets, as it compensates for the risks of investing in these markets. The fact that the analysis finds that financial integration does not seem to matter for productivity growth may also be related to the risk premium that is not captured in the analysis and contributes to the insignificant result of the relationship between the two variables. This means that financial openness alone does not guarantee capital inflows, which may in turn have no significant effect on productivity growth.
The fourth point is that the share of capital in production varies across countries. In many developing countries, the share of capital may be lower, which may affect the degree to which financial openness promotes productivity growth. In addition, the relative price of investment (the price of capital goods) may vary across countries, even if financial openness exists, which makes investment levels differ, and in turn, contributes to the level of productivity growth. Thus, adjustments to the analysis at the country level may be necessary to make the results more comparable, for instance, by categorizing countries based on a certain level of share of capital in production.
The UK and The Global Economy After Brexit
Moving forward to a recent column in the context of financial openness, I agree with Posen (2022) to the extent that several indicators have shown a decreasing trend in the UK since the Brexit vote, including international trade, trade openness, immigrant population, and inward FDI flows. This trend is concerning, as it might indicate that the UK is moving towards a closed economy, which can have multiple harmful effects, such as hindering innovation and hampering productivity growth.
Empirically, part of the reasons for the declining trend in UK trade and investment in particular could be the deep integration level of the European Union (EU) that provides the benefit to trade and investment from being a member. For example, prior to Brexit, the UK benefited from reduced trade costs and trade liberalization, which can improve allocative and productive efficiency in the short run (Crafts, 2016). This might be because the EU has achieved a deeper level of economic integration and there is no close substitute (Baier et al., 2008). For FDI, there is evidence that EU membership has a strong positive effect on FDI because of market access (Slaughter, 2003). Hence, it is reasonable that the UK’s withdrawal from the EU affected the country’s trade and investment.
On the other hand, there is an indication that the UK is moving towards an autarky or a closed economy. Theoretically, the implication for the economy if the UK continues to become more closed cannot be underestimated, as it may face difficulties in obtaining the gain from consumption smoothing. This means that a trade-off could occur in the economy if the UK wants to make more investments by reducing consumption to compensate for the increase in investment.
However, it should be noted that the evidence presented should be interpreted with caution, and further analysis may be required to make a more accurate conclusion, as correlation does not necessarily mean causality. This means other factors could also influence the decline in selected indicators, such as the 2020 pandemic. In my point of view, the pandemic in 2020 might have exacerbated the effect of Brexit; hence, the impact of Brexit, if there had been no pandemic, might not have been as large as if there had been a pandemic. While the COVID-19 pandemic and Brexit are two separate events that have had significant economic impacts on the UK, their combined effects may exacerbate the negative economic impacts on the country.
There are several potential arguments for this hypothesis. First, the global pandemic of 2020 has had an adverse effect on numerous economies worldwide. Empirical studies indicate that the COVID-19 outbreak has had a severely negative impact on cross-border activities, including trade, investment, and the movement of people (Hayakawa et al., 2022; Moosa and Merza, 2022). It is reasonable to assume that lockdowns, travel restrictions, and other measures implemented by governments to curb the spread of the virus have led to a decrease in trade flows and a slowdown in economic activity.
Second, the pandemic could exacerbate the negative economic effects of Brexit by causing significant disruptions in global supply chains and international trade. For example, a report published in 2021 suggested that Brexit has resulted in changes to migration and trade regimes, which have further aggravated the supply bottlenecks caused by the pandemic (Office for Budget Responsibility, 2021).
Third, the COVID-19 outbreak may magnify the impact of Brexit by exposing different sectors of the economy compared with those exposed to Brexit alone. This implies that in most cases, the regions and sectors most affected by the economic impact of COVID-19 are distinct from those likely to be most affected by Brexit, as reported by the Trade Union Congress (2020). For example, the manufacturing of automotive, transport equipment, chemicals and chemical products, and textiles, as well as services such as finance and communications, are among the sectors most exposed to Brexit. On the other hand, the hospitality, tourism, transport, arts, and entertainment sectors are among those most exposed to the economic impact of COVID-19. The automotive industry is one of the sectors that has experienced a decline due to the pandemic and is likely to be significantly impacted by Brexit. Thus, the combined effect of both crises would have a more extensive impact on the UK than either would have had independently.
In conclusion, while financial openness can have a positive impact on productivity growth, the analysis presented by Prasad, Terrones, and Kose (2009) needs to be considered with caution. There are several factors to take into account, including differences in productivity levels between countries, the importance of social efficiency, the risk premium, and the share of capital in production. Similarly, the decline in UK trade and investment since Brexit may be partially attributed to the deep integration of the European Union, but further analysis is required to determine causality. The COVID-19 pandemic may have also exacerbated the negative economic effects of Brexit by causing significant disruptions in global supply chains and international trade. Therefore, it is important to conduct further research to understand the complex interplay between these factors and their impact on the economy.
References
Baier, S. L., Bergstrand, J., Egger, P., & McLaughlin, P. (2008). Do Economic Integration Agreements Actually Work? Issues in Understanding the Causes and Consequences of the Growth of Regionalism. The World Economy, 31, 461-497.
Crafts, N. (2016). The Growth Effects of EU Membership for the UK: Review of the evidence. Global Perspectives Series: Paper 7, 1-26.
Hayakawa, K., Lee, H., & Park, C. (2022). The Effect of Covid-19 on Foreign Direct Investment. ADB Economics Working Paper Series No. 653
Moosa, I. A., & Merza, E. (2022). The effect of COVID-19 on foreign direct investment inflows: stylised facts and some explanations. Future Business Journal, 8(1), 20.
Posen, A. (2022, April 27). The UK and the global economy after Brexit. Peterson Institute for International Economics. https://www.piie.com/research/piie-charts/uk-and-global-economy-after-brexit
Prasad, E., Terrones, M. and Kose, M. (2009, January 5). Financial globalisation and productivity growth. VoxEU. http://voxeu.org/article/financial-globalisation-and-productivity-growthLinks to an external site.
Slaughter, M. (2003). Host Country Determinants of US Foreign Direct Investment into Europe in H. Hermann and R. Lipsey (eds.), Foreign Direct Investment in the Real and Financial Sector of Industrial Countries. Berlin: Springer, 7-32.
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