The Impact of Financial Openness on Economic Integration: Evidence from the Europe and the Cis

Empirical definition of financial openness and international financial integration
Crucial to the estimation of equations (3) and (6) is the empirical definition of the
variable z, the degree of financial openness. This should capture the extent to which a
country does not restrict capital movements across borders. At the same time,
however, it should not be based on the actual volume of cross-holdings of foreign
assets and liabilities, as in this case it would be a measure of international financial
integration rather than financial openness. A suitable strategy, indeed rather common
in the literature, is to construct an index of capital account liberalisation using the
information available from the IMF's Annual Report on Exchange Arrangements and
Exchange Restrictions (AREAR) ¹⁶. We follow the approach proposed by Chinn and
Ito (2001) and construct our variable z as follows.

From the AREAR we define for each country and each year four dummies: (i) R1
takes value 1 in the absence of multiple exchange rates, (ii) R2 takes value 1 if current
account transactions are not restricted, and (iii) R3 takes value 1 if capital account
transactions are not restricted, (iv) R4 takes value 1 in the absence of a requirement of
surrender of export proceeds. A variable SHARE3 is then constructed for each year as
the average of R3 in that year and in the four preceding years. Finally, z is obtained for
each country and each year as the first standardised principal component of R1, R2,
SHARE3 and R4. Thus, z is a indicator of overall cross-border capital liberalisation:
higher values denote greater financial openness.

Equations (3) and (6) will also be estimated replacing the indicator of financial
openness z by two measures of international financial integration taken from Lane and
Milesi-Ferretti (2003):
where, as usual, i denotes a country and t a given year, FA is the stock of foreign
assets, FL is the stock of foreign liabilities, PEA and PEL are the stocks of portfolio
equity assets and liabilities respectively, FDIA and FDIL are the stock of foreign
direct investment assets and liabilities respectively. Thus, the variable p1 measures the

¹⁶ See Miniane (2004) for a survey of various approaches adopted in the construction of such indices.

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