Capital account liberalization and financial deepening: Does the private sector matter?

This paper tests, using cross-sectional and Generalized Method of Moments (GMM) dynamic panel estimation techniques, the effect of freeing cross-border financial transactions on financial sector development for a sample of 90 developed and developing countries over the period 1980-2009. it tests, specifically, if the effect of financial integration on financial deepening depends on some prerequisites in the economy. The main results of the paper are the following: First, in developing countries financial integration is not found to lead to higher financial development unless a set of prerequisites are already in place. Second, to have successful capital account liberalization in middle income countries, there is a need to develop the institutional environment and the private sector as prerequisites. Third, the effect of freeing cross-border capital flows on economic growth is found to depend on the same prerequisites in these countries.