Private Capital inflow and Growth in Former Soviet-bloc Countries: Roles of Stock Market and Demand-side Macroeconomic Policy.

• Author: Suliman, Adil H.

1. Introduction

   Most of the former Soviet states began the transition process to a market economy in 1990-1991, they made great efforts to restructure their economic systems to free market economies, these restructuring processes triggered out many negative changes, with GDP falling by more than forty percent, spending in health, education, and other social programs are reduced. By 1995, these negative declines are reversed with the cumulative effect of market reforms, and the GDP began to recover in most of these states. This research examines the roles of financial market and the government's demand-side policy as intermediaries that can propagate the influence of capital inflow on economic growth. We use data on 10 former soviet-bloc transition countries (see footnote (1) for the names of these countries) between 1990 and 2015 and conduct tests specifications within this block to endorse and support the result. (2)

   Many previous studies have confirmed that private capital inflow has a positive influence on economic growth and promotes economic performance. For example, Borensztein et al.. (1998) indicate that capital inflows have positive impact on local savings and investment, leading to the crowding-in effect rather than the crowding-out effect, resulting in an increase in knowledge spill over and market efficiency. Similar results can be found in Perrault (2002), Vo (2010), Choong et al. (2010) and Kinda (2012).

   The study is different from previous studies by extending the "Lucas paradox" approach by examining missing important variables such as physical infrastructure and financial development. The literature also supports that the domestic financial market and the demand-side macroeconomic policy are both important non-linear channels that stimulate economic growth. The demand-side policy has direct effects on economic growth, as well as indirect effects by stimulating saving and investment. In this way, a proper demand-side policy is considered as a channel through which investors minimize risk. On the other hand, some previous studies McKinnon and Pill (1997), Calvo (1998), Reisen and Soto (2001) and Kose et al. (2004) show that the risks associated with private capital flow may have negative impact on economic growth in host countries.

   Given that these countries examined in this study are emerging economies, we examine whether economic growth in these countries has been led by the stock market and/or demand-side macroeconomic policy reforms, allowing for non-linear relationship between economic growth and capital inflow. Under this context, we do the following: First, we examine the effect of private capital inflow on growth. Private capital inflow is measured using foreign direct investment (FDI) and foreign portfolio investments (FPI).Second, given that the literature support the notion that the causation between private capital inflow and economic growth is better supported when there are sound economic and financial policies implemented, we examine how financial policy and demand-side macroeconomic policy influence the relationship between private capital inflow and economic growth. Consumption expenditure is used as a proxy for fiscal policy, and inflation is used as a proxy for monetary policy in order to measure the effect of demand-side macroeconomic policy on growth. The government's stabilization policy is considered to be the main aspect that can create an environment conducive to capital accumulation of saving and investment. Prior studies have argued that a government's fiscal policy and monetary policy can both be considered indicators of economic stability.

   Finally, some previous studies conclude that for private capital inflows to be beneficial to economic growth, the following important mechanisms must first be in place, human capital (De Mello1997), trade policy (Bhagwati1978), technology spillovers (Barro and Sala-i-Martin 1995), and financial development and economic policy (Greenwood and Jovanovic 1990; Levine and Zervos1998a,b). Many of these studies found that both stock market capitalization and stock market liquidity has been found in the literature to affect economic growth directly and indirectly through investment and physical capital accumulation. (3)

   To examine how domestic financial market influence the relationship between economic growth and capital inflows, both stock market capitalization as percentage of GDP (MarketCapitalization) and stock market total value traded as percentage of GDP (StockTrading)are used as proxy for domestic financial market. Both proxies are interacted with both types of capital inflow. The following interaction terms are included in the regression, (FDI*MarketCapitalization), (FDI*StockTrading), (FPI*MarketCapitalization), and (FPI*StockTrading). In addition, to further authenticate our findings in this study, we control for interaction between gross saving as a percentage of GDP (GossSaving) and both types of capital inflow by using the following interaction terms: FDI (-1) * GrossSaving and FPI (-1) * Gross saving, the government's stabilization policy is considered to be the main aspect that can create an environment conducive to capital accumulation of saving and investment that generated through the flow of private capital.

   A set of "free" control variables appear in every growth regression, these include the initial level of income, the initial education rate, trade, and average population growth. Base on the availability of the data and initial statistical specifications tests, we control for the following set of control variables: GDP per capita, Purchasing Power Parity (PPP), in current US dollars (GDP per Capita); annual percentage change in the population (PopulationGrowth); trade (Trade), measured by both exports and imports as a percentage of GDP; education (Education),measured by secondary education, pupils; and saving (Gross saving)measured by gross saving as a percentage of GDP.

   Several features of this study separate its contributions from the existing body of literature on the subject. First, we examine the mechanisms or channels through which private capital inflows and economic growth can interact. Second, we focus on a developing emerging market that had suffered under financial and institutional repression for a long period before they straighten their macroeconomic policies. Third, given the data limitation, we use dynamic panel data models. Specifically, generalized method of moments (GMM) technique used to deal with the endogeneity and other econometric problems. Finally, private capital flows is considered as a main channel of stimulating economic growth in Former Soviet-bloc Countries.

   This paper is organized as follows. Section 2 of this paper provides a review of existing literature. Section 3, develops a theoretical framework and the theory underlying in this study. In section 4, the results are presented and explained. Section 5 summaries the conclusion drawn from this study.

2. Literature Review

   Previous empirical studies (see Rao (2015) for a review (4))), there is a mixed support for the hypothesis that FDI has a positive and significant impact on economic growth in developing countries (Elmawazini eta al. 2016) (5). Borensztein et al. (1998)...