Financial Openness and Growth: Short‐run Gain, Long‐run Pain?

No empirical evidence has yet emerged for the existence of a robust positive relationship between financial openness and economic growth. This paper argues that a key reason for the elusive evidence is the presence of a time‐varying relationship between openness and growth: countries tend to gain in the short term, immediately following capital account liberalization, but may not grow faster or even experience temporary growth reversals in the medium to long term. The paper finds substantial empirical evidence for the existence of such an intertemporal tradeoff for 45 industrialized and emerging market economies. The acceleration of growth immediately after liberalization is found to be often driven by an investment boom and a surge in portfolio and debt inflows. By contrast, the quality of domestic institutions, the size of FDI inflows and the sequencing of the liberalization process are found to be important driving forces for growth in the medium to longer term.