How Financial Freedom and Integration Change Public Debt Impact on Financial Development in the Asia‐Pacific: A Panel Smooth Transition Regression Approach

• Published date: 01 December 2018
• DOI: http://doi.org/10.1111/1467-8462.12279
• Date: 01 December 2018
• Author: Duy‐Tung Bui

How Financial Freedom and Integration Change Public Debt

Impact on Financial Development in the Asia-Pacif‌ic: A Panel

Smooth Transition Regression Approach

Duy-Tung Bui*

Abstract

This study investigates the non-linear effect of

f‌iscal policy (measured by total domestic

public sector debt) on the level of f‌inancial

development, using a balanced panel of 22

economies in the Asia-Pacif‌ic region. Govern-

ments in less developed f‌inancial institutional

infrastructure (for instance, emerging markets)

tend to abuse their power by intervening in the

domestic debt market. This study shows that

better f‌inancial institutional infrastructure

helps to discipline governments. The results

suggest a negative effect of domestic public

sector debt on f‌inancial development, but only

at low level of f‌inancial freedom and integra-

tion. Higher f‌inancial freedom and f‌inancial

integration would reduce the crowding-out

effect of domestic public sector debt.

1. Introduction

A large number of studies investigate institu-

tional factors as determinants of f‌inancial

development

1

(Chinn and Ito 2002; Law and

Habibullah 2009; Huang 2010; Voghouei,

Azali and Law 2011; Le, Kim and Lee

2016). However, this study offers a new

perspective on this issue. To be more specif‌ic,

this article focuses on the impact of public

sector debt on f‌inancial development with the

interaction of f‌inancial institutional factors. In

this research, I argue that public sector credit

can crowd out private sector credit, but the

crowding-out effect can be mitigated through

improvement of f‌inancial institutional factors.

In certain economies, especially in emerging

countries with low level levels of f‌inancial

institutional infrastructure, governments can

abuse their power by intervening in the

domestic debt market to f‌inance their expendi-

ture. This f‌iscally irresponsible behaviour is

well-documented in Caballero and Krishna-

murthy (2004). In this article, I show that better

f‌inancial institutional development can shape

this ‘prodigal’behaviour.

In recent decades, economies in the Asia-

Pacif‌ic region have started reforming and

restructuring their f‌inancial systems. However,

the level of f‌inancial development in this region

is still lower than that of developed countries.

In addition, the performance of the f‌inancial

sector is not as dynamic as the real sector

(for instance, the manufacturing industries)

(Estrada, Park and Ramayandi 2010). There are

also concerns about f‌inancial development in

this region. The f‌irst issue relates to the size of

the f‌inancial system. A group of Asia-Pacif‌ic

countries, particularly in East Asia, have

* University of Economics Ho Chi Minh City, School of

Public Finance, and the University of Burgundy, Labo-

ratoire d’Economie de Dijon, EA 7467; e-mail <tungbd@

ueh.edu.vn>. The author acknowledges the funding

support of the University of Economics Ho Chi Minh

City, Viet Nam.

The Australian Economic Review, vol. 51, no. 4, pp. 486–501 DOI: 10.1111/1467-8462.12279

°

C2018 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

Published by John Wiley & Sons Australia, Ltd

expanded their f‌inancial systems beyond their

income levels. This overheated growth of the

f‌inancial sector does not necessarily relate to

f‌inancial development as a great deal of their

savings are channelled through the f‌inancial

systems of the developed world. Second, this

unhealthy expansion is linked to unsustainable

f‌inancial development. Several banking sys-

tems in the region (for example, China) are

dominated by state-owned banks. These banks

may take advantage of their available funds to

invest in huge government projects or state-

owned f‌irms, to the detriment of the private

sector (see later discussion on ‘lazy banks’).

This behaviour may be the source of f‌inancial

instability and poor investment quality (Aizen-

man, Jinjarak and Park 2015). Furthermore, the

dominant role of state-owned banks in this

bank-based f‌inancial system may aggravate the

situation. Governments in this system have

more power to channel funds into their

expenditure, compared to a market-based

f‌inancial system. In fact, banking activities

are still prevalent in the f‌inancial systems in the

Asia-Pacif‌ic region, especially in Central Asia

and the Pacif‌ic (Estrada et al. 2010; Le et al.

2016).

In the previous paragraphs, I argue that

public sector borrowing can be detrimental to

the private sector (the so-called crowding-out

effect is discussed further in Section 2).

However, the literature also shows that public

debt can have certain benef‌its for the private

sector. Thus, the relationship between public

debt and private sector debt is not necessarily

linear. To investigate this possible non-linear

relationship, I build a panel smooth transition

regression model (PSTR), developed by

Gonz

alez, Ter€

asvirta and van Dijk (2005). A

PSTR model can be understood as a regime-

switching model that has a certain number of

extreme regimes. It assumes that the transition

from one regime to another depends on the

value of a threshold variable or transition

variable (for instance, the level of f‌inancial

institutional development). In a panel setup,

using a PSTR model provides two main

benef‌its. First, this model allows for correction

of heterogeneity and instability. The coeff‌i-

cients of the regressors in the model are

allowed to vary among individual units and

across time. Thus, it can be considered a

parametric approach of cross-sectional hetero-

geneity and time instability of the coeff‌icients.

Second, in comparison with a panel threshold

model (PTR), the coeff‌icients of a PSTR model

for a given individual at a given time do not

need to be identical to the estimated coef-

f‌icients of the extreme regimes (Colletaz and

Hurlin 2006).

The previous literature takes little notice of

the role of f‌iscal policy as a determinant of

f‌inancial development. Hauner (2009) suggests

that the insignif‌icant relationship is the result

of poor f‌iscal variables selection. Previous

authors tend to measure f‌iscal policy by using

the overall def‌icit, government expenditure as a

percentage of GDP or public debt as a

percentage of GDP (Boyd, Levine and Smith

2001; S

aez, Gallego and Herrero 2003).

However, these proxies often include irrelevant

information. For instance, overall def‌icit

includes external f‌inancing and non-bank

f‌inancing, which blurs the relationship between

overall def‌icit and f‌inancial depth. Following

Hauner (2009), I use a ‘closer’indicator of

f‌iscal policy to f‌inancial depth, which is the

total domestic credit to government and state-

owned enterprises. Then, I develop two main

hypotheses that allow the investigation of the

non-linear effect of public sector debt on

f‌inancial development.

This study contributes to the literature in

several ways. First, by contrast with the

previous literature, which focuses on political

or economic institutions, this article concen-

trates on f‌inancial institutional factors. I

believe that these factors have the most direct

inf‌luence on the f‌inancial sector. Second, few

empirical studies have been published on the

non-linear relationship between f‌iscal policy

and f‌inancial development, despite a number of

theoretical frameworks on the issue (Caballero

and Krishnamurthy 2004; Ozkan, Kipici and

Ismihan 2010; Ismihan and Ozkan 2012).

Third, to my knowledge, this is the f‌irst study

incorporating heterogeneity in studying the

crowding-out effect of public sector debt.

The rest of the article is organised as

follows. Section 2 provides a brief review of

Bui: Public Debt and Financial Development 487

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C2018 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research