NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Effect of Opening Equity Markets on Economic Volatility

"In 40 countries that had removed restrictions on foreign portfolio investment or 'liberalized,' 26 experienced a decrease in growth volatility after liberalization while 14 recorded an increase."

Many countries worry that opening domestic stock markets and other financial markets to foreign investors exposes them to the potentially volatile mood swings of the global economy, with riches rushing in one day, ushering in new wealth, only to suddenly rush out on another day, leaving economic ruin in their wake. But in Growth Volatility and Financial Market Liberalization (NBER Working Paper No. 10560), co-authors Geert Bekaert, Campbell Harvey, and Christian Lundblad find that opening up financial markets has no effect on economic volatility and, by more broadly spreading risk, actually can, in some cases, make things calmer than they were before liberalization. "It is often claimed that liberalizing equity markets leads to excessive volatility," the authors state. "Our research suggests that this statement is not supported by the data."

Bekaert, Harvey, and Lundblad looked for the effects of liberalization by probing various countries for evidence that making financial markets more accessible to foreigners was followed by potentially destabilizing swings in purchases of goods and services -- something they call "consumption growth volatility." They note that financial crises of the 1990s in Mexico and Southeast Asia "focused attention" on the notion that when foreign speculative capital can simply leave "at a whim," entire economies are destined to suffer much sharper changes. But the authors found that in general, economic conditions are not more volatile in countries that make it easier for outsiders to invest.

They found that in 40 countries that had removed restrictions on foreign portfolio investment or "liberalized," 26 experienced a decrease. Bekaert, Harvey, and Lundblad discovered that the countries experiencing the greatest reduction in volatility were those that had opened both equity markets and the capital account. That is, countries that made it easier for foreign investors to buy domestic stocks and also to move money into and out of the country at their individual discretion were the least likely to experience increased volatility.

These findings appear to challenge the notion advanced by some policy experts that countries, particularly emerging markets, should institute some form of capital control to keep sudden monetary inflows or outflows from destabilizing internal economic conditions. For example, Chile is often singled out for praise as having shielded itself from global market volatility by making it relatively difficult for investors to quickly withdraw their cash from the country. But Bekaert, Harvey, and Lundblad said that their "results suggest that maximum decreased volatility occurs when both the equity market liberalizes and the capital account is open." They find that Chile's lower volatility is related to the development of their social security system rather than to their relatively closed capital account.

In addition, when the authors confined their analysis to emerging markets -- those generally considered most likely to suffer the negative effects of liberalization -- for the most part, opening up equity markets did not "lead to a significant change in consumption growth volatility." "This is an important result," they state, "because (previous studies have) mostly assumed that liberalization leads to significant increases in volatility."

Overall, they note their failure to find a link between liberalization and increased consumption growth volatility is "remarkable" considering that their analysis includes conditions that prevailed in 1998, when the Asian economic crises prompted a precipitous drop in consumption in places like Korea, Thailand, and Indonesia. The authors did find instances in which other factors could cause a move toward market liberalization to spark an increase in volatility.

Bekaert, Harvey, and Lundblad caution that their observations address only the "average effects" of financial market liberalization. They note that an individual country's ability to take advantage of the positive benefits of financial market liberalization is closely tied to the overall quality of its government institutions and financial markets. "Our research suggests that if the country is economically fragile, has low quality institutions and a poorly developed financial sector, equity market liberalization may not reduce real variability at all," they write.

-- Matthew Davis


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