capital accumulation (h) and a constant term (c)12. The empirical model for income
gap between country i and country j at time t is thus given by:
(3) dyt = α0 +α1dnt +α2dht +α3dkt +α4dzt + εt
where d denotes the difference between country j and country i (i.e. dyt = yjt - yit; dnt
= njt - nit; and so forth), α0 = cj∙ - ci, εt is a normally distributed stochastic disturbance
term, and the a’s are parameters to be estimated. Note that if α4 > 0, then the more
country i falls behind country j in terms of financial openness, the larger the income-
gap will be. This means that to reduce the income-gap, country i will have to increase
its degree of financial openness for any given degree of financial openness achieved
by the partner j. The role of financial openness in the process of per-capita income
convergence can thus be tested through the null hypothesis H0 : α4 = 0.
Two modifications of equation (3) will be considered. First, as discussed in the
introduction, it is important to separate the effect of financial openness from that of
domestic financial development. For this purpose, a term dqt, where q is a proxy of
the depth of domestic financial intermediation, will be added to equation (3). Second,
as several theoretical models predict that financial openness will impact on per-capita
income by directly affecting the rate of physical capital accumulation, the inclusion of
the term dkt might bias the estimated α4 downward, thus leading to the conclusion that
financial openness is not significant when it actually is. For this reason, equation (3)
will be estimated both with and without dkt. As it will turn out, the null hypothesis H0
: α4 = 0 is rejected in both cases.
The second equation estimated in this paper is a gravity model of bilateral trade. The
gravity approach posits that the volume of trade between two partners is positively
related to their economic size and inversely related to their distance. This approach
has received wide empirical support and recent studies have shown how it can be
closely linked to formal theories of international trade13 . Therefore, it seems to be the
most appropriate tool to test whether financial openness promotes trade integration.
12 The underlying assumption being that technology grows at a constant rate and that its initial level is
equal to a constant plus a white noise. See Mankiw et al. (1992).
13 For a discussion of gravity equations, see, inter alia, Evenett and Keller (2002).