Capital mobility in the panel GMM framework: evidence from EU members.

• Author: Ketenci, Natalya
• Position: Generalized method of moments - Report

1. Introduction

   Many studies on international capital mobility in the literature have been inspired by the seminal work of Feldstein and Horioka (1980), who examined the level of capital mobility in OECD countries, estimating the following equation:

   [(IYR).sub.it] = [[alpha].sub.0] + [beta][(SYR).sub.it] + [e.sub.it] (1)

   Where IYR is the ratio of gross domestic investment to gross domestic product, JYR is the ratio of the gross domestic savings to the gross domestic product of the country i at period t. Coefficient [beta], which is known as a saving retention coefficient, measures the degree of capital mobility. High international capital mobility refers to low correlation between investments and saving flows, or the value of [beta], is supposed to be close to 0. A low level of capital mobility in a country suggests a low correlation between investments and saving flows, or the value of the saving retention coefficient is supposed to be close to 1, indicating the capital immobility of the country. Feldstein and Horioka (1980) found that the value of the saving retention coefficient for developed countries is closer to 1 than to 0 value, illustrating by this international capital immobility in the estimated countries. These controversial results gave start to widespread debates in the economic literature. Numerous studies have provided evidence supporting these results, but other results exist in the literature with a wide array of interpretations.

   Various literature reviews were made related to the Feldstein Horioka Puzzle, for example, Tesar (1991), Frankel (1992), Coakley et al. (1998), Obstfeld and Rogoff (2000), and the latest updated literature review by Apergis and Tsoumas (2009). Obstfeld and Rogoff (2000) referred to the findings of Feldstein and Horioka (1980), which are indeed contrary to economic theory, as "the mother of all puzzles." Frankel (1992) argued that the Feldstein Horioka puzzle is not that surprising as it can be explained by the failure of some form of interest rate parity, for which arguments such as transaction costs and regulations can be made. The author suggested that the high value of the coefficient may be due to the procyclicality of savings and investments. Obstfeld and Rogoff (2000) suggested that the high value of the saving retention coefficient is due to the "home bias" in investor preferences. Apergis and Tsoumas (2009) concluded that the results of the majority of studies support a high correlation between savings and investments, but at a lower level. At the same time, they indicate that most studies do not validate the capital mobility hypothesis.

   Most empirical studies with panel data have concentrated on large samples of OECD countries following the work of Feldstein and Horioka (1980) (see, for example, Ho 2002, 2003; Fouquau et al., 2008; Adedeji and Thornton, 2008; Ketenci, 2013), or on smaller samples of OECD countries (Georgopoulos and Hejazi, 2009; Rao et al., 2010; Narayan and Narayan, 2010). Another group of studies narrows its focus to EU countries (for example, Feldstein and Bachetta, 1991; Artis and Byoumi, 1991; Banerjee and Zanghieri, 2003; Telatar et al., 2007; Kollias et al., 2008; Ketenci, 2012).

   Fouquau et al. (2008) in their study on OECD countries employed a panel smooth threshold regression approach proposed by Gonzalez et al. (2005) that can capture heterogeneity across countries and the time variability of the saving retention coefficient. The threshold variables considered in the study by Fouquau et al. (2008) are the economic growth of the analyzed countries, demography, degree of openness, country size, and current account balance. The authors found that the highest impacts on the international capital mobility are degree of openness, country size, and current account balance. It was found that the countries in the sample have a heterogeneous degree of international capital mobility, and that the estimated saving retention coefficients have a tendency to decline in the estimated period, between 1960 and 1990.

   Ho (2003), for example, employed only a country-size threshold variable for measuring its impact on the saving retention coefficient. The study was conducted for the panel of 23 OECD countries, covering the period from 1961 to 1997. The author provided substantial evidence of the threshold effects of the country size variable on the saving retention coefficient, which can be a partial explanation of Feldstein Horioka Puzzle. Ketenci (2013) estimated the saving retention coefficient for four groups of OECD countries: OECD, EU15, NAFTA, and G7 samples. The results of the study indicated that the saving retention coefficient estimates are sensitive to panel selection. Thus, the high saving retention coefficient was found at the 0.784 level only for the G7 group, while the saving retention coefficients for other groups were detected at lower levels, rejecting the hypothesis of the Feldstein Horioka Puzzle existence.

   The degree of capital mobility between EU countries has to be above the capital mobility between OECD countries due to the presence of homogenous institutions, the degree of financial openness, and regulations in the EU. This hypothesis is supported in many studies. For example, Feldstein and Bachetta (1991) and Artis and Byoumi (1991) compared EU and OECD countries in their studies on savings-investment relations and on financial integration. In both studies, the results were in favor of the higher degree of the capital mobility inside the EU than between OECD members. Kollias et al. (2008), in their studies on Feldstein Horioka Puzzle across EU members using the ARDL bounds approach and panel data, illustrated that the savings-retention coefficient for EU15 is 0.148, and that this coefficient increases to 0.157 when Luxemburg is excluded from the panel. Therefore, the estimations of this study provided evidence of high capital mobility in the group of EU members, which contradicts the findings of Feldstein-Horioka (1980) for OECD countries.

   Investment and saving flows are exposed to various changes in domestic as well as in world economies. Recently, more authors have started to take into account the presence of structural breaks or regime shifts using different econometric techniques. See, for example, Ozmen and Parmaksiz (2003), Telatar et al. (2007), Mastroyiannis (2007), Kejriwal (2008), Rao et al. (2010), and Ketenci (2012). Ozmen and Parmaksiz (2003), in their capital mobility analysis of the UK, and Mastroyiannis (2007), in his capital mobility analysis of Greece, did not find evidence supporting Feldstein Horioka Puzzle in the presence of structural breaks.

   Telatar et al. (2007) employed the Markov-switching model to examine the behavior of saving retention coefficients in the presence of regime change. In their study of several European countries they found evidence of increasing capital mobility in Belgium, Denmark, Finland, France, Italy and Sweden after the regime change in 1994, which was the year of the establishment of the EU. They confirmed that the saving retention coefficient declined after taking into account the regime change. Kejriwal (2008), as well as the above-mentioned authors, did not find evidence of the existence of Feldstein Horioka Puzzle in European countries in the presence of structural breaks. However, the author argues that the reason for the overstated saving retention coefficients in the literature can be in the misspecification of regression models. Ketenci (2012) employed the Gregory and Hansen (1996) cointegration test in the presence of one structural break and the Johansen cointegration test with dummy variables, located at known points for structural dates. The results of this empirical research illustrated a low level saving retention coefficient estimated in the presence of structural breaks. The results indicate high capital mobility in most of the countries, providing evidence against Feldstein Horioka Puzzle in the European Union countries sample.

   This study investigates the degree of capital mobility in EU members using the panel Generalized Method of Moments (GMM) approach and its dynamic model. At the same time, it inquires into the effect of the global financial crisis on capital mobility employing dummy variables for different years and periods of the crisis. In the case of perfect capital mobility, investment depends on the rate of interest; however, the decisions of investors very often depend on experience of previous decades having dynamic nature. The level of international capital mobility is exposed to various changes in domestic as well as in world economies. Particularly the global financial crisis had an impact on developed economies where fluctuations of capital flows are considered to have been one of main reasons for the crisis spread.

   This topic has received significant coverage in the literature. See, for example, Baldwin (2009), Fratzscher (2011), Milesi-Ferretti and Tille (2011), and Broner et al. (2013). Broner et al. (2013), for example, argue that gross capital flows are pro-cyclical and follow economic cycles. Particularly gross...