Financial Reform What Shakes It What Shapes It

By ABDUL ABIAD AND ASHOKA MODY

What accounts for the worldwide advance of financial reforms in the last quartercentury Using a new index of financial liberalization we find that influential eventsshook the policy status quo Balance-of-payments crises spurred reforms butbanking crises set liberalization back Falling global interest rates strengthenedreformers while new governments went both ways The overall trend towardliberalization however reflected pressures and incentives generated by initialreforms that raised the likelihood of additional reforms stimulated further by theneed to catch up with regional reform leaders In contrast ideology and countrystructure had limited influence (JEL P11 P16 P34 N20 G28)

In the last quarter of the twentieth centuryfinancial systems worldwide moved from gov-ernment ownership or control toward greaterprivate provision of financial services underfewer operational restrictions These liberaliza-tion efforts varied considerably howeveracross countries in timing speed and magni-tude occasionally previous reforms were re-versed Using a newly constructed index offinancial liberalization we document trends infinancial sector liberalization and ask when byhow much and why did countries reform

A large and technically sophisticated litera-ture has examined the consequences of finan-cial sector liberalization but the causes ofliberalization have received less attention AsliDemirguc-Kunt and Enrica Detragiache (2001)and Graciela L Kaminsky and Carmen M Re-inhart (1999) discuss the causality from finan-cial liberalization to economic crises But forexample do crises induce reforms Countrycase studies provide support for various eco-

nomic and political theories of policy change1

Case studies however have obvious limitationsand as Allan Drazen (2000 p 449) notes ldquo itis striking how little formal empirical testingthere has beenrdquo2

A successful statistical examination of liber-alization has to meet two challenges First pol-icy changes tend to be episodic and the triggersfor these episodes need to be identified How-ever the episodes themselvesmdashleading to bothliberalizations and reversalsmdashare embedded ina long-term process that in the past quartercentury has trended toward greater liberaliza-tion Thus the second challenge is to identify adynamic process that leads to these cumulativetransformations

We pursue a political economy perspective inexplaining the timing pace and extent of finan-cial sector reforms The starting point of theanalysis is an observed bias toward retaining thestatus quo as established interest groups com-

Abiad International Monetary Fund 700 19th St NWWashington DC 20431 (e-mail aabiadimforg) ModyInternational Monetary Fund 700 19th St NW Washing-ton DC 20431 (e-mail amodyimforg) The authors aregrateful to participants in the third Political Economy ofInternational Finance Conference seminar participants at ajoint IMF-World Bank seminar and Eduardo BorenszteinSalim Darbar Toni Gravelle Simon Johnson Russell Kin-caid Aart Kraay Alex Mourmouras Jacques Polak Car-men Reinhart Antonio Spilimbergo Hung Tran LilianaSchumacher Michael Tomz David Walker and two anon-ymous referees for valuable comments

1 Individual country studies can be found in Robert HBates and Anne O Krueger (1993) John Williamson(1994) Judith Teichman (1997) and Sebastian Edwardsand Roberto Steiner (2000) among others

2 Michael Bruno and William Easterly (1996) and Dra-zen and Easterly (2001) test whether hyperinflations (crises)have been followed by substantially lower inflation imply-ing that reforms were implemented Eduardo Lora and Mau-ricio Olivera (2004) investigate the role of crises in thetiming and sequencing of reforms in Latin America Ra-ghuram G Rajan and Luigi Zingales (2002) investigate thedeterminants of financial development (a proxy for reform)and Dennis P Quinn (2000) examines the impact of democ-racy on capital account liberalization

66

promise to maintain the existing policy regimeFrom the literature we identify three sources ofreforms First reforms may be triggered bydiscrete events or ldquoshocksrdquo that change thebalance of decision-making power These in-clude crises the formation of a new govern-ment changes in global interest rates andleverage exercised by international financial in-stitutions (Anne O Krueger 1993) Secondldquolearningrdquo may foster reform by revealing in-formation that causes reassessment of the costsand benefits of the policy regime Learning canalso help resolve the impasse on account ofuncertainty regarding the identity of winners(Raquel Fernandez and Dani Rodrik 1991)The term ldquolearningrdquo thus is shorthand for bothdiscovery and the consequent realignments inrelationships3 Domestic learning may be sup-plemented by international ldquodiffusionrdquo as coun-tries move to global or regional norms tocompete for international capital (Beth A Sim-mons and Zachary Elkins 2004) And finallyreforms may be conditioned by the ideology ofthe ruling government (Alberto Alesina andNouriel Roubini 1992 Alex Cukierman andMariano Tommasi 1998) and such structuralfeatures as openness to trade (Raghuram GRajan and Luigi Zingales 2003) legal system(Rafael La Porta et al 1997) and form ofgovernment (Torsten Persson 2002)

This paper provides an integrated empiricalframework to examine the forces producingtransitions to financial liberalization The possi-bility of domestic learning implies a dynamicrelationship between the level of financial sectorliberalization and subsequent policy changesundertaken The paper specifies such a relation-ship and within that context identifies the otherfactors that further strike at the status quo

One constraint in analyzing the determinantsof policy changes has been the lack of a cross-country measure of financial liberalization Weuse a newly constructed financial liberalizationindex which covers 35 countries annually from1973 to 1996 and allows a more precise deter-mination than previously possible of the timingand significance of various events cumulating in

a financial liberalization process The indexmeasures the removal of government controland direction of the financial sector Althoughwe use reform and liberalization interchange-ably throughout the paper we do not take astand on the desirability or otherwise of somefinancial policies that may be regarded as con-troversial that is a matter to be analyzed whenassessing the consequences of the reforms un-dertaken Recognizing the multifaceted andmultistage nature of financial reform the indexis an aggregation along six dimensions directedcreditreserve requirements interest rate controlsentry barriers andor lack of pro-competitionpolicies restrictive operational regulations thedegree of privatization in the financial sectorand controls on international financial transac-tions On each dimension a country is classifiedas being fully repressed partially repressedlargely liberalized or fully liberalized

To allow for the discrete nature of liberaliza-tion we use the ordered logit technique to an-alyze the determinants of reform Our resultssuggest that shocks mattered and a self-reinforcing reform momentum was essentialwhile ideology and structure played only a mod-est role in the liberalization process What typesof economic and political events shook the sta-tus quo Among external influences reformswere promoted by a decline in US interestrates and by participation in programs of theInternational Monetary Fund (IMF) though thelatter effect was pronounced mainly in countrieswhere financial sectors were highly repressedA balance-of-payments crisis typically trig-gered financial sector reforms but banking cri-ses set liberalization back The tendency towardstatus quo weakened during a chief executiversquosfirst year in office but changes included rever-sals as well as reforms While these variousevents were influential the findings are alsoconsistent with a learning process that shapedand sustained reforms Countries with highlyrepressed financial sectors tended to stay thatway but once initial reforms occurred the pro-cess gained momentum and future reforms be-came more likely Learning also occurredthrough observing regional reform leaders In-terestingly ideology and structure seem to havehad limited influence on the reform process Forexample left-wing governments were no lessreform-oriented than right-wing governments

3 In the context of trade policy reform Krueger (1997)suggests that learning occurred as a lagged adjustment toeconomic research that documented the benefits of reform

67VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

presidential and parliamentary regimes wereequally inclined to reform and legal systemsdid not hinder the move to liberalize Greatertrade openness however appears to have in-creased the pace of reform where the level ofliberalization was low

The paper is organized as follows In SectionI we describe the database of financial liberal-ization episodes compare it to other measuresof financial liberalization and briefly highlightthe salient features of financial reform over thepast 25 years Section II summarizes the rele-vant literature on the political economy of re-form focusing on the reasons for status quo biasand the conditions under which policy changesbecome more likely In Section III we examineone at a time selected factors associated withpolicy changes Section IV presents multivari-ate analysis and includes several extensions totest the robustness of the results Section Vconcludes

I Financial Liberalization 1973ndash1996

The new index used in this study considersvarious financial sector policies in 35 countriesover the 24-year period from 1973 to 1996 Sixpolicy dimensions are inputs to the creation ofan aggregate index of the degree of policy lib-eralization They include

(a) Credit controls such as directed credit to-ward favored sectors or industries ceilingson credit toward other sectors and exces-sively high reserve requirements

(b) Interest rate controls including whether thegovernment directly controls interest ratesor whether floors ceilings or interest ratebands exist

(c) Entry barriers in the banking sector such aslicensing requirements limits on the partic-ipation of foreign banks and restrictionsrelating to bank specialization or the estab-lishment of universal banks

(d) Operational restrictions such as on staffingbranching and advertising and the estab-lishment of securities markets

(e) Privatization in the financial sector and(f) Restrictions on international financial trans-

actions such as on capital and current ac-count convertibility and the use of multipleexchange rates

Along each dimension a country is given ascore on a graded scale with zero correspond-ing to being fully repressed one to partiallyrepressed two to largely liberalized and threeto fully liberalized4 Policy changes then de-note shifts in a countryrsquos score on this scale ina given year In some cases such as whenstate-owned banks are privatized all at once orwhen controls on all interest rates are simulta-neously abolished policy changes will corre-spond to jumps of more than one unit along thatdimension Reversals such as the imposition ofcapital controls or interest rate controls arerecorded as shifts from a higher to a lowerscore

Identifying the various policy changes in-cluded in our database was facilitated by theavailable surveys of financial liberalization ex-periences such as those of Jose Maria Fanelliand Rohinton Medhora (1998) John William-son and Molly Mahar (1998) R Barry Johnstonand Vasudevan Sundararajan (1999) Gordon deBrouwer and Wisarn Pupphavesa (1999) andGerard Caprio et al (2001) Nevertheless fre-quent use of other resources such as centralbank bulletins and Web sites IMF country re-ports books and journal articles was madewhen information was unclear or incompletereferences for each country are identified in thedatabase itself

Table 1 reports the correlations among the sixcomponents of financial liberalization Somesubcomponents show a higher correlation indi-cating that the liberalizations along these di-mensions tended to occur together The threemeasures most frequently used as indicators offinancial repressionmdashcredit controls interestrate controls and controls on international fi-nancial transactionsmdashare highly correlated witheach other with the correlations ranging from

4 Although the gradations are necessarily subjectiveguidelines were used to reduce the subjectivity For exam-ple interest rates were considered fully repressed where thegovernment set all interest rates partially repressed whereinterest rates were allowed to vary within a band or subjectto a ceiling or floor largely liberalized if some interest rateswere allowed to be completely market-determined (or ifnew floating rate instruments were introduced) and fullyliberalized where all interest rate restrictions were removedA detailed description of how the database was constructedand how the sources were used as well as a description ofthe database itself can be found at wwwamodycom

68 THE AMERICAN ECONOMIC REVIEW MARCH 2005

promise to maintain the existing policy regimeFrom the literature we identify three sources ofreforms First reforms may be triggered bydiscrete events or ldquoshocksrdquo that change thebalance of decision-making power These in-clude crises the formation of a new govern-ment changes in global interest rates andleverage exercised by international financial in-stitutions (Anne O Krueger 1993) Secondldquolearningrdquo may foster reform by revealing in-formation that causes reassessment of the costsand benefits of the policy regime Learning canalso help resolve the impasse on account ofuncertainty regarding the identity of winners(Raquel Fernandez and Dani Rodrik 1991)The term ldquolearningrdquo thus is shorthand for bothdiscovery and the consequent realignments inrelationships3 Domestic learning may be sup-plemented by international ldquodiffusionrdquo as coun-tries move to global or regional norms tocompete for international capital (Beth A Sim-mons and Zachary Elkins 2004) And finallyreforms may be conditioned by the ideology ofthe ruling government (Alberto Alesina andNouriel Roubini 1992 Alex Cukierman andMariano Tommasi 1998) and such structuralfeatures as openness to trade (Raghuram GRajan and Luigi Zingales 2003) legal system(Rafael La Porta et al 1997) and form ofgovernment (Torsten Persson 2002)

This paper provides an integrated empiricalframework to examine the forces producingtransitions to financial liberalization The possi-bility of domestic learning implies a dynamicrelationship between the level of financial sectorliberalization and subsequent policy changesundertaken The paper specifies such a relation-ship and within that context identifies the otherfactors that further strike at the status quo

One constraint in analyzing the determinantsof policy changes has been the lack of a cross-country measure of financial liberalization Weuse a newly constructed financial liberalizationindex which covers 35 countries annually from1973 to 1996 and allows a more precise deter-mination than previously possible of the timingand significance of various events cumulating in

a financial liberalization process The indexmeasures the removal of government controland direction of the financial sector Althoughwe use reform and liberalization interchange-ably throughout the paper we do not take astand on the desirability or otherwise of somefinancial policies that may be regarded as con-troversial that is a matter to be analyzed whenassessing the consequences of the reforms un-dertaken Recognizing the multifaceted andmultistage nature of financial reform the indexis an aggregation along six dimensions directedcreditreserve requirements interest rate controlsentry barriers andor lack of pro-competitionpolicies restrictive operational regulations thedegree of privatization in the financial sectorand controls on international financial transac-tions On each dimension a country is classifiedas being fully repressed partially repressedlargely liberalized or fully liberalized

To allow for the discrete nature of liberaliza-tion we use the ordered logit technique to an-alyze the determinants of reform Our resultssuggest that shocks mattered and a self-reinforcing reform momentum was essentialwhile ideology and structure played only a mod-est role in the liberalization process What typesof economic and political events shook the sta-tus quo Among external influences reformswere promoted by a decline in US interestrates and by participation in programs of theInternational Monetary Fund (IMF) though thelatter effect was pronounced mainly in countrieswhere financial sectors were highly repressedA balance-of-payments crisis typically trig-gered financial sector reforms but banking cri-ses set liberalization back The tendency towardstatus quo weakened during a chief executiversquosfirst year in office but changes included rever-sals as well as reforms While these variousevents were influential the findings are alsoconsistent with a learning process that shapedand sustained reforms Countries with highlyrepressed financial sectors tended to stay thatway but once initial reforms occurred the pro-cess gained momentum and future reforms be-came more likely Learning also occurredthrough observing regional reform leaders In-terestingly ideology and structure seem to havehad limited influence on the reform process Forexample left-wing governments were no lessreform-oriented than right-wing governments

3 In the context of trade policy reform Krueger (1997)suggests that learning occurred as a lagged adjustment toeconomic research that documented the benefits of reform

67VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

presidential and parliamentary regimes wereequally inclined to reform and legal systemsdid not hinder the move to liberalize Greatertrade openness however appears to have in-creased the pace of reform where the level ofliberalization was low

The paper is organized as follows In SectionI we describe the database of financial liberal-ization episodes compare it to other measuresof financial liberalization and briefly highlightthe salient features of financial reform over thepast 25 years Section II summarizes the rele-vant literature on the political economy of re-form focusing on the reasons for status quo biasand the conditions under which policy changesbecome more likely In Section III we examineone at a time selected factors associated withpolicy changes Section IV presents multivari-ate analysis and includes several extensions totest the robustness of the results Section Vconcludes

I Financial Liberalization 1973ndash1996

The new index used in this study considersvarious financial sector policies in 35 countriesover the 24-year period from 1973 to 1996 Sixpolicy dimensions are inputs to the creation ofan aggregate index of the degree of policy lib-eralization They include

(a) Credit controls such as directed credit to-ward favored sectors or industries ceilingson credit toward other sectors and exces-sively high reserve requirements

(b) Interest rate controls including whether thegovernment directly controls interest ratesor whether floors ceilings or interest ratebands exist

(c) Entry barriers in the banking sector such aslicensing requirements limits on the partic-ipation of foreign banks and restrictionsrelating to bank specialization or the estab-lishment of universal banks

(d) Operational restrictions such as on staffingbranching and advertising and the estab-lishment of securities markets

(e) Privatization in the financial sector and(f) Restrictions on international financial trans-

actions such as on capital and current ac-count convertibility and the use of multipleexchange rates

Along each dimension a country is given ascore on a graded scale with zero correspond-ing to being fully repressed one to partiallyrepressed two to largely liberalized and threeto fully liberalized4 Policy changes then de-note shifts in a countryrsquos score on this scale ina given year In some cases such as whenstate-owned banks are privatized all at once orwhen controls on all interest rates are simulta-neously abolished policy changes will corre-spond to jumps of more than one unit along thatdimension Reversals such as the imposition ofcapital controls or interest rate controls arerecorded as shifts from a higher to a lowerscore

Identifying the various policy changes in-cluded in our database was facilitated by theavailable surveys of financial liberalization ex-periences such as those of Jose Maria Fanelliand Rohinton Medhora (1998) John William-son and Molly Mahar (1998) R Barry Johnstonand Vasudevan Sundararajan (1999) Gordon deBrouwer and Wisarn Pupphavesa (1999) andGerard Caprio et al (2001) Nevertheless fre-quent use of other resources such as centralbank bulletins and Web sites IMF country re-ports books and journal articles was madewhen information was unclear or incompletereferences for each country are identified in thedatabase itself

Table 1 reports the correlations among the sixcomponents of financial liberalization Somesubcomponents show a higher correlation indi-cating that the liberalizations along these di-mensions tended to occur together The threemeasures most frequently used as indicators offinancial repressionmdashcredit controls interestrate controls and controls on international fi-nancial transactionsmdashare highly correlated witheach other with the correlations ranging from

4 Although the gradations are necessarily subjectiveguidelines were used to reduce the subjectivity For exam-ple interest rates were considered fully repressed where thegovernment set all interest rates partially repressed whereinterest rates were allowed to vary within a band or subjectto a ceiling or floor largely liberalized if some interest rateswere allowed to be completely market-determined (or ifnew floating rate instruments were introduced) and fullyliberalized where all interest rate restrictions were removedA detailed description of how the database was constructedand how the sources were used as well as a description ofthe database itself can be found at wwwamodycom

68 THE AMERICAN ECONOMIC REVIEW MARCH 2005

presidential and parliamentary regimes wereequally inclined to reform and legal systemsdid not hinder the move to liberalize Greatertrade openness however appears to have in-creased the pace of reform where the level ofliberalization was low

The paper is organized as follows In SectionI we describe the database of financial liberal-ization episodes compare it to other measuresof financial liberalization and briefly highlightthe salient features of financial reform over thepast 25 years Section II summarizes the rele-vant literature on the political economy of re-form focusing on the reasons for status quo biasand the conditions under which policy changesbecome more likely In Section III we examineone at a time selected factors associated withpolicy changes Section IV presents multivari-ate analysis and includes several extensions totest the robustness of the results Section Vconcludes

I Financial Liberalization 1973ndash1996

The new index used in this study considersvarious financial sector policies in 35 countriesover the 24-year period from 1973 to 1996 Sixpolicy dimensions are inputs to the creation ofan aggregate index of the degree of policy lib-eralization They include

(a) Credit controls such as directed credit to-ward favored sectors or industries ceilingson credit toward other sectors and exces-sively high reserve requirements

(b) Interest rate controls including whether thegovernment directly controls interest ratesor whether floors ceilings or interest ratebands exist

(c) Entry barriers in the banking sector such aslicensing requirements limits on the partic-ipation of foreign banks and restrictionsrelating to bank specialization or the estab-lishment of universal banks

(d) Operational restrictions such as on staffingbranching and advertising and the estab-lishment of securities markets

(e) Privatization in the financial sector and(f) Restrictions on international financial trans-

actions such as on capital and current ac-count convertibility and the use of multipleexchange rates

Along each dimension a country is given ascore on a graded scale with zero correspond-ing to being fully repressed one to partiallyrepressed two to largely liberalized and threeto fully liberalized4 Policy changes then de-note shifts in a countryrsquos score on this scale ina given year In some cases such as whenstate-owned banks are privatized all at once orwhen controls on all interest rates are simulta-neously abolished policy changes will corre-spond to jumps of more than one unit along thatdimension Reversals such as the imposition ofcapital controls or interest rate controls arerecorded as shifts from a higher to a lowerscore

Identifying the various policy changes in-cluded in our database was facilitated by theavailable surveys of financial liberalization ex-periences such as those of Jose Maria Fanelliand Rohinton Medhora (1998) John William-son and Molly Mahar (1998) R Barry Johnstonand Vasudevan Sundararajan (1999) Gordon deBrouwer and Wisarn Pupphavesa (1999) andGerard Caprio et al (2001) Nevertheless fre-quent use of other resources such as centralbank bulletins and Web sites IMF country re-ports books and journal articles was madewhen information was unclear or incompletereferences for each country are identified in thedatabase itself

Table 1 reports the correlations among the sixcomponents of financial liberalization Somesubcomponents show a higher correlation indi-cating that the liberalizations along these di-mensions tended to occur together The threemeasures most frequently used as indicators offinancial repressionmdashcredit controls interestrate controls and controls on international fi-nancial transactionsmdashare highly correlated witheach other with the correlations ranging from

4 Although the gradations are necessarily subjectiveguidelines were used to reduce the subjectivity For exam-ple interest rates were considered fully repressed where thegovernment set all interest rates partially repressed whereinterest rates were allowed to vary within a band or subjectto a ceiling or floor largely liberalized if some interest rateswere allowed to be completely market-determined (or ifnew floating rate instruments were introduced) and fullyliberalized where all interest rate restrictions were removedA detailed description of how the database was constructedand how the sources were used as well as a description ofthe database itself can be found at wwwamodycom

68 THE AMERICAN ECONOMIC REVIEW MARCH 2005

076 to 082 Less correlated are the measures offinancial liberalization relating to entry barriersand regulations The measure of privatization inthe financial sector has the lowest correlationwith the other components an indication thatprivatization does not coincide with other re-forms In the rest of this paper we focus on theaggregate index leaving the analysis of thecomponents to future research

The measures along the six dimensions canbe aggregated to obtain an index of overallfinancial liberalization for each country in eachyear Various aggregation methods producedvery similar measures so in this paper we sim-ply use the sum of the individual components5

Since each of the six indices can take on valuesbetween 0 and 3 the sum takes on values be-tween 0 and 18 These aggregate measures offinancial liberalization are tabulated for eachcountry in the Data Appendix

In parallel with our research recent papershave constructed alternative measures of finan-cial liberalization Hali J Edison and Francis EWarnock (2003) calculate the proportion of to-tal stock market capitalization that is availableto foreign investors for 29 emerging marketsfrom 1989ndash2000 This is in the spirit of ourmeasure inasmuch as it provides a graded indexof liberalization over time It is not a broad-based indicator of financial sector liberalization

however being narrowly focused on restrictionson foreign portfolio equity investment

Closer in scope to our measure is the indexconstructed by Kaminsky and Sergio LSchmukler (2003) which has three compo-nents domestic financial sector liberalizationespecially of interest rate and credit controlscapital account liberalization and the opennessof the equity market to foreign investment Asin our approach each component takes discretevalues being classified as ldquofully liberalizedrdquoldquopartially liberalizedrdquo or ldquorepressedrdquo Althoughthe building blocks of the Kaminsky-Schmuklerdatabase are similar to ours their measure putsmore weight on liberalization of internationalcapital flows whereas ours emphasizes reformsin the domestic financial sector Kaminsky andSchmukler extend their index to 1999 but theirsample of countries is smaller covering 14 de-veloped and 14 developing countries Finallytwo datasetsmdashOriana Bandiera et al (2000) andLuc Laeven (2003)mdashcharacterize financial lib-eralization along the same six dimensions as ourdatabase The country coverage in each case ismuch smaller however with 8 and 13 countriescovered respectively Moreover neither datasetgrades the components treating them instead asbinary variables

Despite the differences in the construction ofthese datasets they show the same broad pat-terns of financial sector reform as does ourindex6 We draw four broad conclusions on thetime profile of liberalization First despitestops gaps and reversals liberalization ad-vanced through much of the world in the lastquarter century (Figure 1) Countries in all

5 Four aggregation methods were explored a simplesum the first principal component the sum of squares(which overweights large changes in a single component sothat major reforms in one dimension are deemed to be moresignificant than minor progress in many) and the sum ofsquare roots (minor progress along many dimensions isdeemed to be more effective than major progress in justone) All four aggregation methods produced overall mea-sures that were highly comparablemdashcorrelations among thevarious series were mostly above 95 percent and none wasbelow 90 percent

6 Our key empirical findings reported in Section V be-low on the central importance of domestic and regionallearning are robustly present when we use the Kaminsky-Schmukler index

TABLE 1mdashCORRELATIONS AMONG FINANCIAL LIBERALIZATION COMPONENTS

Creditcontrols

Interest ratecontrols

Entrybarriers Regulations Privatization

Internationaltransactions

Credit controls 100Interest rate controls 082 100Entry barriers 065 066 100Regulations 069 068 058 100Privatization 059 051 038 061 100International transactions 077 076 059 074 059 100

69VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

income groups liberalized though higher-in-come economies remained more liberalizedthan lower-income economies throughout

Second while trends appear smooth in thesecountry averages the reform process at thecountry level was typically characterized bylong periods of status quo or no change inpolicy To facilitate the exposition we classifypolicy changes for each country-year into fivecategories A decrease in the financial liberal-ization measure of 3 or more points is classifiedas a large reversal a decrease of 1 or 2 points asa reversal an increase of 1 or 2 points as areform and an increase of 3 or more points asa large reform Finally years in which no pol-icy changes were undertaken are classified as

status quo observations Table 2 shows thedistribution of various policy changes in thewhole sample as well as by region Status quoobservations represent the large majority ofobservationsmdashover 76 percent of the wholesample Reforms constitute another 15 percentof the sample and large reforms account foranother 5 percent Reversals are relatively rareand large reversals even more so There weretwo large reversals in the sample and bothoccurred in Latin Americamdashin Argentina in1982 and in Venezuela in 1994

Third there is evidence of regional cluster-ing countries within certain regions havetended to liberalize their financial sectors atroughly the same time and in roughly the same

FIGURE 1 FINANCIAL LIBERALIZATION BY INCOME GROUP 1973ndash1996

TABLE 2mdashDISTRIBUTION OF FINANCIAL POLICY CHOICES FULL SAMPLE AND BY REGION

(In percent)

Fullsample

LatinAmerica

EastAsia

SouthAsia

AfricaMiddle East OECD

Large reform 51 62 75 35 36 44Reform 154 143 143 174 123 178Status quo 762 739 739 757 826 757Reversal 31 44 44 35 15 22Large reversal 03 12 00 00 00 00

Total 1000 1000 1000 1000 1000 1000

70 THE AMERICAN ECONOMIC REVIEW MARCH 2005

way7 With the exception of early reforms inArgentina and Chile in the 1970s most of thereforms in Latin America were clustered in thelate 1980s and early 1990s (Figure 2) The twoexceptions Chile and Argentina also illustratethat reform is not a steady march forward bothcountries reversed policy during the debt crisisof 1982ndash1983 The process of financial liberal-ization in East Asia was much more gradualCountries opened up their financial sectors insmall steps in the early 1980s with the wholereform process stretching over a decade in mostcases South Asian financial sectors remain atleast partially repressed even at the end of oursample period South Asiarsquos reforms occurredin the early to mid-1990s with the exception ofSri Lanka which undertook a major reformeffort in 1978

Finally four of the OECD countries (Ger-many Canada the United Kingdom and theUnited States) already had liberalized financialsectors at the beginning of our sample periodThe rest of the OECD countries in our samplestarted the period with relatively repressed fi-

nancial systems but caught up and now havelargely or fully liberalized financial sectors via agradual process that began in the late 1970s andearly 1980s Only New Zealand adopted a one-shot approach undertaking most of its financialreforms in 1984ndash1985

II The Political Economy of Reform

The policy status quo will persist as long asthe benefits of maintaining it outweigh the coststo those who determine the timing and pace ofreform Theories of economic reforms fall intothree broad categories (a) ldquoshocksrdquo alter thebalance of decision-making power leading toboth reforms and reversals (b) perceived pay-offs are updated using new information whichwe refer to as ldquolearningrdquo and (c) ideology andpolitical and economic structure condition thepace at which policy change occurs We discusseach possibility briefly

Reflecting case-study evidence Krueger(1993 p124) summarizes ldquoMost reforms seemto take place in one of two circumstances eithera new government comes to power or a per-ceived economic crisis prompts actionrdquo Newincumbents have an incentive to undertake re-forms early to realize their benefits before thenext election Stephan Haggard and Steven B

7 Two OECD member countries Korea and Mexico areincluded in their regional grouping rather than in the OECDgroup The income categories are based on the grouping inthe World Bankrsquos 2001 World Development Indicators

FIGURE 2 FINANCIAL LIBERALIZATION BY REGION 1973ndash1996

71VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

Webb (1993 p 148) while sympathetic to andnoting several cases in favor of the ldquonew gov-ernmentrdquo or ldquohoneymoonrdquo hypothesis alsopoint out that ldquodemocratic leaders in ArgentinaBolivia and Brazil pursued more expansionistpolicies in their early days and delayed neededreformrdquo Similarly a crisis creates the potentialfor reform by destabilizing cooperation amongdifferent interest groups (see for exampleAaron Tornell 1998 and Drazen 2000) Criseshowever may also overwhelm reform capabil-ity Joan M Nelson (1990 p 326) notes epi-sodes where authorities ldquodelayed and waveredin the face of a startlingly sudden crisis indeedone reason for ineffective reactions was thespeed of deterioration which ran far ahead ofdata collection and analysisrdquo Eduardo Lora andMauricio Olivera (2004) examine a wide varietyof reforms and find that crises appear to play arole in certain types of reforms but not in others

Among other sources of external influenceleading to reforms Leonardo Bartolini and Dra-zen (1997) argue that when international capitalcan be accessed cheaply incentives for reformare strong and the likelihood of liberalizingincreases8 Also international financial institu-tions may be able to induce reform acting onbehalf of domestic ldquooutsidersrdquo such as thoseexcluded from access to credit and savers whoreceive low returns on their financial assetsHaggard and Webb (1993) find the evidence isinconclusive with respect to the influence exer-cised by international financial institutions

Fernandez and Rodrik (1991) conclude thatuncertainty with respect to reform outcomes cancreate a bias toward maintaining the policy sta-tus quo (see also Adam Przeworski 1991 RaulLaban and Federico Sturzenegger 1994a and1994b) If individuals or interest groups do notknow ex ante who among them will benefitfrom reform they may oppose the policychange even if it is socially optimal and a ma-jority will benefit ex post If however reform isa multistage process then early reform mayhelp agents assess whether they will benefit orlose from reform Krueger (1993 p 127) notes

that following an initially successful reformprogram ldquostrong political interests opposed toreform are to a considerable extent neutralized new interests emerge favoring the altered eco-nomic policiesrdquo Even incumbents who initiallyoppose reforms sometimes become the stron-gest advocates for further reforms

Learning may also have external sources Re-cent contributions to the political economy ofreformmdashand to the spread of democracymdashhavenoted a spatial clustering of activity and havetherefore postulated a regional diffusion effect(for recent reviews see Daniel M Brinks andMichael Coppedge 2001 Simmons and Elkins2004) The theories underlying regional dif-fusion are as yet speculative but they rely es-sentially on economic social and politicalsimilarities of neighboring nations and hencethe relevance of their experience in informingdomestic policy debates (John V OrsquoLoughlin etal 1998 Robert Axelrod 1997) Simmons andElkins (2004) who find strong evidence forregional effects conclude that countries withina region compete for the same international poolof risk capital

With respect to ideology the conventional viewis that right-wing governments are more receptiveto market-oriented reforms such as financial lib-eralization (For a discussion of partisan versusopportunistic politicians see for exampleAlesina and Roubini 1992) However where theelectorate cannot easily distinguish if a policyproposal is motivated by partisan considerationsor by concerns for social welfare a right-wingpolicy proposed by a left-wing government maybe vested with more credibility being more likelyto be motivated by social rather than ideologicalconcerns This Cukierman and Tommasi (1998)argue is especially true when rare and large re-forms are being proposed

Other political and economic structural fac-tors have been proposed as conducive to reformPersson (2002) argues that the presidential formof government is less prone than parliamentarysystems to the logjam arising from conflictinginterests La Porta et al (1997) emphasize theimportance of legal systems as do Ross Levineet al (2000) Rajan and Zingales (2003) suggestthat when economies are more open to interna-tional trade and investment new opportunitiespartially compensate ldquoinsidersrdquo for lost rentswhile ldquooutsidersrdquo such as foreign banks have a

8 Conversely high world interest rates are likely to trig-ger controls except for those countries Bartolini and Dra-zen (1997) argue which desire to signal their commitmentto liberalization (and hence attract future investment) bymaintaining their openness

72 THE AMERICAN ECONOMIC REVIEW MARCH 2005

continuing incentive to push for further finan-cial liberalization

In summary reform may occur under a richset of conditions raising the challenge of sort-ing out the relative importance of the variousstimulating factors At the same time empiricalconclusions from the case studies on the polit-ical economy of reform and the limited numberof econometric analyses are ambiguous reflect-ing not only the genuine ambiguity in the theoryof reform but also the multifaceted nature ofreform the challenge in identifying the occur-rence and timing of reforms and the furtherdifficulty in defining conditioning events suchas crises By using a more tightly specifiedmeasure of reform than has been available in across-country setting and by paying greater at-tention to the timing of reforms and to theevents that may lead up to them we allow forthe possibility of obtaining more precise findings

III Reform Determinants Bivariate Relationships

The bivariate relationships presented in thissection have the benefit of greater transparency

than the multivariate results in Section IVwhich corroborate these findings Consider firstthe shocks that dislodge the status quo9 Duringan incumbentrsquos first year in office (as identifiedin the World Bankrsquos Database of Political In-stitutions) the proportion of status quo obser-vations drops from 78 percent to 70 percent anda Pearson chi-square test rejects the null hypoth-esis that the rows and columns are independent(Table 3 upper-left panel)10 The likelihood ofreform especially large reforms increaseshowever reversals are also more frequent dur-ing the first year in office Change then is morelikely during the first year in office supporting

9 See the Data Appendix for definitions of the indepen-dent variables used in this paper

10 The standard Pearson chi-square test statistic may beinaccurate if some of the cell frequencies are small Yatesrsquoscorrection is an adjustment to the chi-square when appliedto tables with one or more cells with frequencies less thanfive This correction also referred to as continuity correc-tion is conservative in the sense of making it more difficultto establish significance Throughout this paper we use thismore conservative continuity-corrected Pearson chi-squaretest statistic

TABLE 3mdashFINANCIAL REFORM THE ROLE OF POLITICAL CONDITIONS AND EXTERNAL INFLUENCES

(In percent)

First year in officeHigh world interest

rates

No Yes No Yes

Large reform 39 98 Large reform 52 48Reform 154 153 Reform 170 110Status quo 777 699 Status quo 751 791Reversal 30 37 Reversal 25 48Large reversal 00 12 Large reversal 02 05

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1252 Pearson Chi-sq 538

Prob 001 Prob 025

IMF program

No Yes

Large reform 46 66Reform 144 183Status quo 772 732Reversal 36 19Large reversal 03 00

Total 1000 1000Pearson Chi-sq 342

Prob 049

73VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

the opportunistic politician theory and the im-portance of the electoral cycle Though chi-square statistics are not significant high USinterest rates (when the US Treasury Bill rateis in the top quartile) are associated with lowerreform and higher reversal likelihood (upper-right panel of Table 3) and IMF programs ap-pear to have a positive reform bias (Table3 lower-left panel)

Table 4 relates financial reform to differenttypes of crises In response to a balance-of-payments crisis the likelihood of a large re-form increases from 31 percent to 97percent The Pearson chi-square test rejectsthe null hypothesis that the distribution ofpolicy changes is independent of the occur-rence of a crisis at the 1-percent level Incontrast when a country is in a banking crisisthe likelihood of a large financial reform fallsfrom 55 percent to 26 percent and the pos-sibility of reversals (large or small) increasesfrom 23 percent to 95 percent Finally re-cessions (defined simply as negative GDPgrowth) and high inflation (defined as an an-

nual inflation rate exceeding 50 percent) in-crease the likelihood of reforms and reversals

To assess the relevance of the learning pro-cess we ask if the distribution of policy changesvaries with the level of financial liberalization ina country One might surmise that countrieswith highly repressed financial sectors are mostlikely to reform as they have the most potentialfor liberalizing This is not quite the case Wefind that countries with highly repressed finan-cial systems tend to stay that way reflected intheir high proportion of status quo observations(Table 5 first column) But after initial liberal-ization further reforms become more likelyThus reforms are more probable in an interme-diate range of liberalizationmdasheither partiallyrepressed or largely liberalized Finally whenfinancial sectors are liberalized (the fourth col-umn) reform possibilities are saturated Theliberalized state seems to be an absorbing statenone of the countries that reach the liberalizedstate undertook reversals of previous reformsThe inverse U-shaped relationship between thelevel of financial liberalization and the inci-

TABLE 4mdashFINANCIAL REFORM THE ROLE OF CRISES

(In percent)

Balance-of-payments crisis Banking crisis

No Yes No Yes

Large reform 31 97 Large reform 55 26Reform 152 158 Reform 158 130Status quo 787 705 Status quo 764 748Reversal 31 32 Reversal 23 78Large reversal 00 08 Large reversal 00 17

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1695 Pearson Chi-sq 1540

Prob 000 Prob 000

RecessionHigh (50)

inflation

No Yes No Yes

Large reform 51 49 Large reform 48 76Reform 149 186 Reform 156 141Status quo 771 696 Status quo 769 707Reversal 28 49 Reversal 28 54Large reversal 00 20 Large reversal 00 22

Total 1000 1000 Total 1000 1000Pearson Chi-sq 879 Pearson Chi-sq 1022

Prob 007 Prob 004

74 THE AMERICAN ECONOMIC REVIEW MARCH 2005

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

income groups liberalized though higher-in-come economies remained more liberalizedthan lower-income economies throughout

Second while trends appear smooth in thesecountry averages the reform process at thecountry level was typically characterized bylong periods of status quo or no change inpolicy To facilitate the exposition we classifypolicy changes for each country-year into fivecategories A decrease in the financial liberal-ization measure of 3 or more points is classifiedas a large reversal a decrease of 1 or 2 points asa reversal an increase of 1 or 2 points as areform and an increase of 3 or more points asa large reform Finally years in which no pol-icy changes were undertaken are classified as

status quo observations Table 2 shows thedistribution of various policy changes in thewhole sample as well as by region Status quoobservations represent the large majority ofobservationsmdashover 76 percent of the wholesample Reforms constitute another 15 percentof the sample and large reforms account foranother 5 percent Reversals are relatively rareand large reversals even more so There weretwo large reversals in the sample and bothoccurred in Latin Americamdashin Argentina in1982 and in Venezuela in 1994

Third there is evidence of regional cluster-ing countries within certain regions havetended to liberalize their financial sectors atroughly the same time and in roughly the same

FIGURE 1 FINANCIAL LIBERALIZATION BY INCOME GROUP 1973ndash1996

TABLE 2mdashDISTRIBUTION OF FINANCIAL POLICY CHOICES FULL SAMPLE AND BY REGION

(In percent)

Fullsample

LatinAmerica

EastAsia

SouthAsia

AfricaMiddle East OECD

Large reform 51 62 75 35 36 44Reform 154 143 143 174 123 178Status quo 762 739 739 757 826 757Reversal 31 44 44 35 15 22Large reversal 03 12 00 00 00 00

Total 1000 1000 1000 1000 1000 1000

70 THE AMERICAN ECONOMIC REVIEW MARCH 2005

way7 With the exception of early reforms inArgentina and Chile in the 1970s most of thereforms in Latin America were clustered in thelate 1980s and early 1990s (Figure 2) The twoexceptions Chile and Argentina also illustratethat reform is not a steady march forward bothcountries reversed policy during the debt crisisof 1982ndash1983 The process of financial liberal-ization in East Asia was much more gradualCountries opened up their financial sectors insmall steps in the early 1980s with the wholereform process stretching over a decade in mostcases South Asian financial sectors remain atleast partially repressed even at the end of oursample period South Asiarsquos reforms occurredin the early to mid-1990s with the exception ofSri Lanka which undertook a major reformeffort in 1978

Finally four of the OECD countries (Ger-many Canada the United Kingdom and theUnited States) already had liberalized financialsectors at the beginning of our sample periodThe rest of the OECD countries in our samplestarted the period with relatively repressed fi-

nancial systems but caught up and now havelargely or fully liberalized financial sectors via agradual process that began in the late 1970s andearly 1980s Only New Zealand adopted a one-shot approach undertaking most of its financialreforms in 1984ndash1985

II The Political Economy of Reform

The policy status quo will persist as long asthe benefits of maintaining it outweigh the coststo those who determine the timing and pace ofreform Theories of economic reforms fall intothree broad categories (a) ldquoshocksrdquo alter thebalance of decision-making power leading toboth reforms and reversals (b) perceived pay-offs are updated using new information whichwe refer to as ldquolearningrdquo and (c) ideology andpolitical and economic structure condition thepace at which policy change occurs We discusseach possibility briefly

Reflecting case-study evidence Krueger(1993 p124) summarizes ldquoMost reforms seemto take place in one of two circumstances eithera new government comes to power or a per-ceived economic crisis prompts actionrdquo Newincumbents have an incentive to undertake re-forms early to realize their benefits before thenext election Stephan Haggard and Steven B

7 Two OECD member countries Korea and Mexico areincluded in their regional grouping rather than in the OECDgroup The income categories are based on the grouping inthe World Bankrsquos 2001 World Development Indicators

FIGURE 2 FINANCIAL LIBERALIZATION BY REGION 1973ndash1996

71VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

Webb (1993 p 148) while sympathetic to andnoting several cases in favor of the ldquonew gov-ernmentrdquo or ldquohoneymoonrdquo hypothesis alsopoint out that ldquodemocratic leaders in ArgentinaBolivia and Brazil pursued more expansionistpolicies in their early days and delayed neededreformrdquo Similarly a crisis creates the potentialfor reform by destabilizing cooperation amongdifferent interest groups (see for exampleAaron Tornell 1998 and Drazen 2000) Criseshowever may also overwhelm reform capabil-ity Joan M Nelson (1990 p 326) notes epi-sodes where authorities ldquodelayed and waveredin the face of a startlingly sudden crisis indeedone reason for ineffective reactions was thespeed of deterioration which ran far ahead ofdata collection and analysisrdquo Eduardo Lora andMauricio Olivera (2004) examine a wide varietyof reforms and find that crises appear to play arole in certain types of reforms but not in others

Among other sources of external influenceleading to reforms Leonardo Bartolini and Dra-zen (1997) argue that when international capitalcan be accessed cheaply incentives for reformare strong and the likelihood of liberalizingincreases8 Also international financial institu-tions may be able to induce reform acting onbehalf of domestic ldquooutsidersrdquo such as thoseexcluded from access to credit and savers whoreceive low returns on their financial assetsHaggard and Webb (1993) find the evidence isinconclusive with respect to the influence exer-cised by international financial institutions

Fernandez and Rodrik (1991) conclude thatuncertainty with respect to reform outcomes cancreate a bias toward maintaining the policy sta-tus quo (see also Adam Przeworski 1991 RaulLaban and Federico Sturzenegger 1994a and1994b) If individuals or interest groups do notknow ex ante who among them will benefitfrom reform they may oppose the policychange even if it is socially optimal and a ma-jority will benefit ex post If however reform isa multistage process then early reform mayhelp agents assess whether they will benefit orlose from reform Krueger (1993 p 127) notes

that following an initially successful reformprogram ldquostrong political interests opposed toreform are to a considerable extent neutralized new interests emerge favoring the altered eco-nomic policiesrdquo Even incumbents who initiallyoppose reforms sometimes become the stron-gest advocates for further reforms

Learning may also have external sources Re-cent contributions to the political economy ofreformmdashand to the spread of democracymdashhavenoted a spatial clustering of activity and havetherefore postulated a regional diffusion effect(for recent reviews see Daniel M Brinks andMichael Coppedge 2001 Simmons and Elkins2004) The theories underlying regional dif-fusion are as yet speculative but they rely es-sentially on economic social and politicalsimilarities of neighboring nations and hencethe relevance of their experience in informingdomestic policy debates (John V OrsquoLoughlin etal 1998 Robert Axelrod 1997) Simmons andElkins (2004) who find strong evidence forregional effects conclude that countries withina region compete for the same international poolof risk capital

With respect to ideology the conventional viewis that right-wing governments are more receptiveto market-oriented reforms such as financial lib-eralization (For a discussion of partisan versusopportunistic politicians see for exampleAlesina and Roubini 1992) However where theelectorate cannot easily distinguish if a policyproposal is motivated by partisan considerationsor by concerns for social welfare a right-wingpolicy proposed by a left-wing government maybe vested with more credibility being more likelyto be motivated by social rather than ideologicalconcerns This Cukierman and Tommasi (1998)argue is especially true when rare and large re-forms are being proposed

Other political and economic structural fac-tors have been proposed as conducive to reformPersson (2002) argues that the presidential formof government is less prone than parliamentarysystems to the logjam arising from conflictinginterests La Porta et al (1997) emphasize theimportance of legal systems as do Ross Levineet al (2000) Rajan and Zingales (2003) suggestthat when economies are more open to interna-tional trade and investment new opportunitiespartially compensate ldquoinsidersrdquo for lost rentswhile ldquooutsidersrdquo such as foreign banks have a

8 Conversely high world interest rates are likely to trig-ger controls except for those countries Bartolini and Dra-zen (1997) argue which desire to signal their commitmentto liberalization (and hence attract future investment) bymaintaining their openness

72 THE AMERICAN ECONOMIC REVIEW MARCH 2005

continuing incentive to push for further finan-cial liberalization

In summary reform may occur under a richset of conditions raising the challenge of sort-ing out the relative importance of the variousstimulating factors At the same time empiricalconclusions from the case studies on the polit-ical economy of reform and the limited numberof econometric analyses are ambiguous reflect-ing not only the genuine ambiguity in the theoryof reform but also the multifaceted nature ofreform the challenge in identifying the occur-rence and timing of reforms and the furtherdifficulty in defining conditioning events suchas crises By using a more tightly specifiedmeasure of reform than has been available in across-country setting and by paying greater at-tention to the timing of reforms and to theevents that may lead up to them we allow forthe possibility of obtaining more precise findings

III Reform Determinants Bivariate Relationships

The bivariate relationships presented in thissection have the benefit of greater transparency

than the multivariate results in Section IVwhich corroborate these findings Consider firstthe shocks that dislodge the status quo9 Duringan incumbentrsquos first year in office (as identifiedin the World Bankrsquos Database of Political In-stitutions) the proportion of status quo obser-vations drops from 78 percent to 70 percent anda Pearson chi-square test rejects the null hypoth-esis that the rows and columns are independent(Table 3 upper-left panel)10 The likelihood ofreform especially large reforms increaseshowever reversals are also more frequent dur-ing the first year in office Change then is morelikely during the first year in office supporting

9 See the Data Appendix for definitions of the indepen-dent variables used in this paper

10 The standard Pearson chi-square test statistic may beinaccurate if some of the cell frequencies are small Yatesrsquoscorrection is an adjustment to the chi-square when appliedto tables with one or more cells with frequencies less thanfive This correction also referred to as continuity correc-tion is conservative in the sense of making it more difficultto establish significance Throughout this paper we use thismore conservative continuity-corrected Pearson chi-squaretest statistic

TABLE 3mdashFINANCIAL REFORM THE ROLE OF POLITICAL CONDITIONS AND EXTERNAL INFLUENCES

(In percent)

First year in officeHigh world interest

rates

No Yes No Yes

Large reform 39 98 Large reform 52 48Reform 154 153 Reform 170 110Status quo 777 699 Status quo 751 791Reversal 30 37 Reversal 25 48Large reversal 00 12 Large reversal 02 05

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1252 Pearson Chi-sq 538

Prob 001 Prob 025

IMF program

No Yes

Large reform 46 66Reform 144 183Status quo 772 732Reversal 36 19Large reversal 03 00

Total 1000 1000Pearson Chi-sq 342

Prob 049

73VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

the opportunistic politician theory and the im-portance of the electoral cycle Though chi-square statistics are not significant high USinterest rates (when the US Treasury Bill rateis in the top quartile) are associated with lowerreform and higher reversal likelihood (upper-right panel of Table 3) and IMF programs ap-pear to have a positive reform bias (Table3 lower-left panel)

Table 4 relates financial reform to differenttypes of crises In response to a balance-of-payments crisis the likelihood of a large re-form increases from 31 percent to 97percent The Pearson chi-square test rejectsthe null hypothesis that the distribution ofpolicy changes is independent of the occur-rence of a crisis at the 1-percent level Incontrast when a country is in a banking crisisthe likelihood of a large financial reform fallsfrom 55 percent to 26 percent and the pos-sibility of reversals (large or small) increasesfrom 23 percent to 95 percent Finally re-cessions (defined simply as negative GDPgrowth) and high inflation (defined as an an-

nual inflation rate exceeding 50 percent) in-crease the likelihood of reforms and reversals

To assess the relevance of the learning pro-cess we ask if the distribution of policy changesvaries with the level of financial liberalization ina country One might surmise that countrieswith highly repressed financial sectors are mostlikely to reform as they have the most potentialfor liberalizing This is not quite the case Wefind that countries with highly repressed finan-cial systems tend to stay that way reflected intheir high proportion of status quo observations(Table 5 first column) But after initial liberal-ization further reforms become more likelyThus reforms are more probable in an interme-diate range of liberalizationmdasheither partiallyrepressed or largely liberalized Finally whenfinancial sectors are liberalized (the fourth col-umn) reform possibilities are saturated Theliberalized state seems to be an absorbing statenone of the countries that reach the liberalizedstate undertook reversals of previous reformsThe inverse U-shaped relationship between thelevel of financial liberalization and the inci-

TABLE 4mdashFINANCIAL REFORM THE ROLE OF CRISES

(In percent)

Balance-of-payments crisis Banking crisis

No Yes No Yes

Large reform 31 97 Large reform 55 26Reform 152 158 Reform 158 130Status quo 787 705 Status quo 764 748Reversal 31 32 Reversal 23 78Large reversal 00 08 Large reversal 00 17

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1695 Pearson Chi-sq 1540

Prob 000 Prob 000

RecessionHigh (50)

inflation

No Yes No Yes

Large reform 51 49 Large reform 48 76Reform 149 186 Reform 156 141Status quo 771 696 Status quo 769 707Reversal 28 49 Reversal 28 54Large reversal 00 20 Large reversal 00 22

Total 1000 1000 Total 1000 1000Pearson Chi-sq 879 Pearson Chi-sq 1022

Prob 007 Prob 004

74 THE AMERICAN ECONOMIC REVIEW MARCH 2005

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

way7 With the exception of early reforms inArgentina and Chile in the 1970s most of thereforms in Latin America were clustered in thelate 1980s and early 1990s (Figure 2) The twoexceptions Chile and Argentina also illustratethat reform is not a steady march forward bothcountries reversed policy during the debt crisisof 1982ndash1983 The process of financial liberal-ization in East Asia was much more gradualCountries opened up their financial sectors insmall steps in the early 1980s with the wholereform process stretching over a decade in mostcases South Asian financial sectors remain atleast partially repressed even at the end of oursample period South Asiarsquos reforms occurredin the early to mid-1990s with the exception ofSri Lanka which undertook a major reformeffort in 1978

Finally four of the OECD countries (Ger-many Canada the United Kingdom and theUnited States) already had liberalized financialsectors at the beginning of our sample periodThe rest of the OECD countries in our samplestarted the period with relatively repressed fi-

nancial systems but caught up and now havelargely or fully liberalized financial sectors via agradual process that began in the late 1970s andearly 1980s Only New Zealand adopted a one-shot approach undertaking most of its financialreforms in 1984ndash1985

II The Political Economy of Reform

The policy status quo will persist as long asthe benefits of maintaining it outweigh the coststo those who determine the timing and pace ofreform Theories of economic reforms fall intothree broad categories (a) ldquoshocksrdquo alter thebalance of decision-making power leading toboth reforms and reversals (b) perceived pay-offs are updated using new information whichwe refer to as ldquolearningrdquo and (c) ideology andpolitical and economic structure condition thepace at which policy change occurs We discusseach possibility briefly

Reflecting case-study evidence Krueger(1993 p124) summarizes ldquoMost reforms seemto take place in one of two circumstances eithera new government comes to power or a per-ceived economic crisis prompts actionrdquo Newincumbents have an incentive to undertake re-forms early to realize their benefits before thenext election Stephan Haggard and Steven B

7 Two OECD member countries Korea and Mexico areincluded in their regional grouping rather than in the OECDgroup The income categories are based on the grouping inthe World Bankrsquos 2001 World Development Indicators

FIGURE 2 FINANCIAL LIBERALIZATION BY REGION 1973ndash1996

71VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

Webb (1993 p 148) while sympathetic to andnoting several cases in favor of the ldquonew gov-ernmentrdquo or ldquohoneymoonrdquo hypothesis alsopoint out that ldquodemocratic leaders in ArgentinaBolivia and Brazil pursued more expansionistpolicies in their early days and delayed neededreformrdquo Similarly a crisis creates the potentialfor reform by destabilizing cooperation amongdifferent interest groups (see for exampleAaron Tornell 1998 and Drazen 2000) Criseshowever may also overwhelm reform capabil-ity Joan M Nelson (1990 p 326) notes epi-sodes where authorities ldquodelayed and waveredin the face of a startlingly sudden crisis indeedone reason for ineffective reactions was thespeed of deterioration which ran far ahead ofdata collection and analysisrdquo Eduardo Lora andMauricio Olivera (2004) examine a wide varietyof reforms and find that crises appear to play arole in certain types of reforms but not in others

Among other sources of external influenceleading to reforms Leonardo Bartolini and Dra-zen (1997) argue that when international capitalcan be accessed cheaply incentives for reformare strong and the likelihood of liberalizingincreases8 Also international financial institu-tions may be able to induce reform acting onbehalf of domestic ldquooutsidersrdquo such as thoseexcluded from access to credit and savers whoreceive low returns on their financial assetsHaggard and Webb (1993) find the evidence isinconclusive with respect to the influence exer-cised by international financial institutions

Fernandez and Rodrik (1991) conclude thatuncertainty with respect to reform outcomes cancreate a bias toward maintaining the policy sta-tus quo (see also Adam Przeworski 1991 RaulLaban and Federico Sturzenegger 1994a and1994b) If individuals or interest groups do notknow ex ante who among them will benefitfrom reform they may oppose the policychange even if it is socially optimal and a ma-jority will benefit ex post If however reform isa multistage process then early reform mayhelp agents assess whether they will benefit orlose from reform Krueger (1993 p 127) notes

that following an initially successful reformprogram ldquostrong political interests opposed toreform are to a considerable extent neutralized new interests emerge favoring the altered eco-nomic policiesrdquo Even incumbents who initiallyoppose reforms sometimes become the stron-gest advocates for further reforms

Learning may also have external sources Re-cent contributions to the political economy ofreformmdashand to the spread of democracymdashhavenoted a spatial clustering of activity and havetherefore postulated a regional diffusion effect(for recent reviews see Daniel M Brinks andMichael Coppedge 2001 Simmons and Elkins2004) The theories underlying regional dif-fusion are as yet speculative but they rely es-sentially on economic social and politicalsimilarities of neighboring nations and hencethe relevance of their experience in informingdomestic policy debates (John V OrsquoLoughlin etal 1998 Robert Axelrod 1997) Simmons andElkins (2004) who find strong evidence forregional effects conclude that countries withina region compete for the same international poolof risk capital

With respect to ideology the conventional viewis that right-wing governments are more receptiveto market-oriented reforms such as financial lib-eralization (For a discussion of partisan versusopportunistic politicians see for exampleAlesina and Roubini 1992) However where theelectorate cannot easily distinguish if a policyproposal is motivated by partisan considerationsor by concerns for social welfare a right-wingpolicy proposed by a left-wing government maybe vested with more credibility being more likelyto be motivated by social rather than ideologicalconcerns This Cukierman and Tommasi (1998)argue is especially true when rare and large re-forms are being proposed

Other political and economic structural fac-tors have been proposed as conducive to reformPersson (2002) argues that the presidential formof government is less prone than parliamentarysystems to the logjam arising from conflictinginterests La Porta et al (1997) emphasize theimportance of legal systems as do Ross Levineet al (2000) Rajan and Zingales (2003) suggestthat when economies are more open to interna-tional trade and investment new opportunitiespartially compensate ldquoinsidersrdquo for lost rentswhile ldquooutsidersrdquo such as foreign banks have a

8 Conversely high world interest rates are likely to trig-ger controls except for those countries Bartolini and Dra-zen (1997) argue which desire to signal their commitmentto liberalization (and hence attract future investment) bymaintaining their openness

72 THE AMERICAN ECONOMIC REVIEW MARCH 2005

continuing incentive to push for further finan-cial liberalization

In summary reform may occur under a richset of conditions raising the challenge of sort-ing out the relative importance of the variousstimulating factors At the same time empiricalconclusions from the case studies on the polit-ical economy of reform and the limited numberof econometric analyses are ambiguous reflect-ing not only the genuine ambiguity in the theoryof reform but also the multifaceted nature ofreform the challenge in identifying the occur-rence and timing of reforms and the furtherdifficulty in defining conditioning events suchas crises By using a more tightly specifiedmeasure of reform than has been available in across-country setting and by paying greater at-tention to the timing of reforms and to theevents that may lead up to them we allow forthe possibility of obtaining more precise findings

III Reform Determinants Bivariate Relationships

The bivariate relationships presented in thissection have the benefit of greater transparency

than the multivariate results in Section IVwhich corroborate these findings Consider firstthe shocks that dislodge the status quo9 Duringan incumbentrsquos first year in office (as identifiedin the World Bankrsquos Database of Political In-stitutions) the proportion of status quo obser-vations drops from 78 percent to 70 percent anda Pearson chi-square test rejects the null hypoth-esis that the rows and columns are independent(Table 3 upper-left panel)10 The likelihood ofreform especially large reforms increaseshowever reversals are also more frequent dur-ing the first year in office Change then is morelikely during the first year in office supporting

9 See the Data Appendix for definitions of the indepen-dent variables used in this paper

10 The standard Pearson chi-square test statistic may beinaccurate if some of the cell frequencies are small Yatesrsquoscorrection is an adjustment to the chi-square when appliedto tables with one or more cells with frequencies less thanfive This correction also referred to as continuity correc-tion is conservative in the sense of making it more difficultto establish significance Throughout this paper we use thismore conservative continuity-corrected Pearson chi-squaretest statistic

TABLE 3mdashFINANCIAL REFORM THE ROLE OF POLITICAL CONDITIONS AND EXTERNAL INFLUENCES

(In percent)

First year in officeHigh world interest

rates

No Yes No Yes

Large reform 39 98 Large reform 52 48Reform 154 153 Reform 170 110Status quo 777 699 Status quo 751 791Reversal 30 37 Reversal 25 48Large reversal 00 12 Large reversal 02 05

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1252 Pearson Chi-sq 538

Prob 001 Prob 025

IMF program

No Yes

Large reform 46 66Reform 144 183Status quo 772 732Reversal 36 19Large reversal 03 00

Total 1000 1000Pearson Chi-sq 342

Prob 049

73VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

the opportunistic politician theory and the im-portance of the electoral cycle Though chi-square statistics are not significant high USinterest rates (when the US Treasury Bill rateis in the top quartile) are associated with lowerreform and higher reversal likelihood (upper-right panel of Table 3) and IMF programs ap-pear to have a positive reform bias (Table3 lower-left panel)

Table 4 relates financial reform to differenttypes of crises In response to a balance-of-payments crisis the likelihood of a large re-form increases from 31 percent to 97percent The Pearson chi-square test rejectsthe null hypothesis that the distribution ofpolicy changes is independent of the occur-rence of a crisis at the 1-percent level Incontrast when a country is in a banking crisisthe likelihood of a large financial reform fallsfrom 55 percent to 26 percent and the pos-sibility of reversals (large or small) increasesfrom 23 percent to 95 percent Finally re-cessions (defined simply as negative GDPgrowth) and high inflation (defined as an an-

nual inflation rate exceeding 50 percent) in-crease the likelihood of reforms and reversals

To assess the relevance of the learning pro-cess we ask if the distribution of policy changesvaries with the level of financial liberalization ina country One might surmise that countrieswith highly repressed financial sectors are mostlikely to reform as they have the most potentialfor liberalizing This is not quite the case Wefind that countries with highly repressed finan-cial systems tend to stay that way reflected intheir high proportion of status quo observations(Table 5 first column) But after initial liberal-ization further reforms become more likelyThus reforms are more probable in an interme-diate range of liberalizationmdasheither partiallyrepressed or largely liberalized Finally whenfinancial sectors are liberalized (the fourth col-umn) reform possibilities are saturated Theliberalized state seems to be an absorbing statenone of the countries that reach the liberalizedstate undertook reversals of previous reformsThe inverse U-shaped relationship between thelevel of financial liberalization and the inci-

TABLE 4mdashFINANCIAL REFORM THE ROLE OF CRISES

(In percent)

Balance-of-payments crisis Banking crisis

No Yes No Yes

Large reform 31 97 Large reform 55 26Reform 152 158 Reform 158 130Status quo 787 705 Status quo 764 748Reversal 31 32 Reversal 23 78Large reversal 00 08 Large reversal 00 17

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1695 Pearson Chi-sq 1540

Prob 000 Prob 000

RecessionHigh (50)

inflation

No Yes No Yes

Large reform 51 49 Large reform 48 76Reform 149 186 Reform 156 141Status quo 771 696 Status quo 769 707Reversal 28 49 Reversal 28 54Large reversal 00 20 Large reversal 00 22

Total 1000 1000 Total 1000 1000Pearson Chi-sq 879 Pearson Chi-sq 1022

Prob 007 Prob 004

74 THE AMERICAN ECONOMIC REVIEW MARCH 2005

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

Webb (1993 p 148) while sympathetic to andnoting several cases in favor of the ldquonew gov-ernmentrdquo or ldquohoneymoonrdquo hypothesis alsopoint out that ldquodemocratic leaders in ArgentinaBolivia and Brazil pursued more expansionistpolicies in their early days and delayed neededreformrdquo Similarly a crisis creates the potentialfor reform by destabilizing cooperation amongdifferent interest groups (see for exampleAaron Tornell 1998 and Drazen 2000) Criseshowever may also overwhelm reform capabil-ity Joan M Nelson (1990 p 326) notes epi-sodes where authorities ldquodelayed and waveredin the face of a startlingly sudden crisis indeedone reason for ineffective reactions was thespeed of deterioration which ran far ahead ofdata collection and analysisrdquo Eduardo Lora andMauricio Olivera (2004) examine a wide varietyof reforms and find that crises appear to play arole in certain types of reforms but not in others

Among other sources of external influenceleading to reforms Leonardo Bartolini and Dra-zen (1997) argue that when international capitalcan be accessed cheaply incentives for reformare strong and the likelihood of liberalizingincreases8 Also international financial institu-tions may be able to induce reform acting onbehalf of domestic ldquooutsidersrdquo such as thoseexcluded from access to credit and savers whoreceive low returns on their financial assetsHaggard and Webb (1993) find the evidence isinconclusive with respect to the influence exer-cised by international financial institutions

Fernandez and Rodrik (1991) conclude thatuncertainty with respect to reform outcomes cancreate a bias toward maintaining the policy sta-tus quo (see also Adam Przeworski 1991 RaulLaban and Federico Sturzenegger 1994a and1994b) If individuals or interest groups do notknow ex ante who among them will benefitfrom reform they may oppose the policychange even if it is socially optimal and a ma-jority will benefit ex post If however reform isa multistage process then early reform mayhelp agents assess whether they will benefit orlose from reform Krueger (1993 p 127) notes

that following an initially successful reformprogram ldquostrong political interests opposed toreform are to a considerable extent neutralized new interests emerge favoring the altered eco-nomic policiesrdquo Even incumbents who initiallyoppose reforms sometimes become the stron-gest advocates for further reforms

Learning may also have external sources Re-cent contributions to the political economy ofreformmdashand to the spread of democracymdashhavenoted a spatial clustering of activity and havetherefore postulated a regional diffusion effect(for recent reviews see Daniel M Brinks andMichael Coppedge 2001 Simmons and Elkins2004) The theories underlying regional dif-fusion are as yet speculative but they rely es-sentially on economic social and politicalsimilarities of neighboring nations and hencethe relevance of their experience in informingdomestic policy debates (John V OrsquoLoughlin etal 1998 Robert Axelrod 1997) Simmons andElkins (2004) who find strong evidence forregional effects conclude that countries withina region compete for the same international poolof risk capital

With respect to ideology the conventional viewis that right-wing governments are more receptiveto market-oriented reforms such as financial lib-eralization (For a discussion of partisan versusopportunistic politicians see for exampleAlesina and Roubini 1992) However where theelectorate cannot easily distinguish if a policyproposal is motivated by partisan considerationsor by concerns for social welfare a right-wingpolicy proposed by a left-wing government maybe vested with more credibility being more likelyto be motivated by social rather than ideologicalconcerns This Cukierman and Tommasi (1998)argue is especially true when rare and large re-forms are being proposed

Other political and economic structural fac-tors have been proposed as conducive to reformPersson (2002) argues that the presidential formof government is less prone than parliamentarysystems to the logjam arising from conflictinginterests La Porta et al (1997) emphasize theimportance of legal systems as do Ross Levineet al (2000) Rajan and Zingales (2003) suggestthat when economies are more open to interna-tional trade and investment new opportunitiespartially compensate ldquoinsidersrdquo for lost rentswhile ldquooutsidersrdquo such as foreign banks have a

8 Conversely high world interest rates are likely to trig-ger controls except for those countries Bartolini and Dra-zen (1997) argue which desire to signal their commitmentto liberalization (and hence attract future investment) bymaintaining their openness

72 THE AMERICAN ECONOMIC REVIEW MARCH 2005

continuing incentive to push for further finan-cial liberalization

In summary reform may occur under a richset of conditions raising the challenge of sort-ing out the relative importance of the variousstimulating factors At the same time empiricalconclusions from the case studies on the polit-ical economy of reform and the limited numberof econometric analyses are ambiguous reflect-ing not only the genuine ambiguity in the theoryof reform but also the multifaceted nature ofreform the challenge in identifying the occur-rence and timing of reforms and the furtherdifficulty in defining conditioning events suchas crises By using a more tightly specifiedmeasure of reform than has been available in across-country setting and by paying greater at-tention to the timing of reforms and to theevents that may lead up to them we allow forthe possibility of obtaining more precise findings

III Reform Determinants Bivariate Relationships

The bivariate relationships presented in thissection have the benefit of greater transparency

than the multivariate results in Section IVwhich corroborate these findings Consider firstthe shocks that dislodge the status quo9 Duringan incumbentrsquos first year in office (as identifiedin the World Bankrsquos Database of Political In-stitutions) the proportion of status quo obser-vations drops from 78 percent to 70 percent anda Pearson chi-square test rejects the null hypoth-esis that the rows and columns are independent(Table 3 upper-left panel)10 The likelihood ofreform especially large reforms increaseshowever reversals are also more frequent dur-ing the first year in office Change then is morelikely during the first year in office supporting

9 See the Data Appendix for definitions of the indepen-dent variables used in this paper

10 The standard Pearson chi-square test statistic may beinaccurate if some of the cell frequencies are small Yatesrsquoscorrection is an adjustment to the chi-square when appliedto tables with one or more cells with frequencies less thanfive This correction also referred to as continuity correc-tion is conservative in the sense of making it more difficultto establish significance Throughout this paper we use thismore conservative continuity-corrected Pearson chi-squaretest statistic

TABLE 3mdashFINANCIAL REFORM THE ROLE OF POLITICAL CONDITIONS AND EXTERNAL INFLUENCES

(In percent)

First year in officeHigh world interest

rates

No Yes No Yes

Large reform 39 98 Large reform 52 48Reform 154 153 Reform 170 110Status quo 777 699 Status quo 751 791Reversal 30 37 Reversal 25 48Large reversal 00 12 Large reversal 02 05

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1252 Pearson Chi-sq 538

Prob 001 Prob 025

IMF program

No Yes

Large reform 46 66Reform 144 183Status quo 772 732Reversal 36 19Large reversal 03 00

Total 1000 1000Pearson Chi-sq 342

Prob 049

73VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

the opportunistic politician theory and the im-portance of the electoral cycle Though chi-square statistics are not significant high USinterest rates (when the US Treasury Bill rateis in the top quartile) are associated with lowerreform and higher reversal likelihood (upper-right panel of Table 3) and IMF programs ap-pear to have a positive reform bias (Table3 lower-left panel)

Table 4 relates financial reform to differenttypes of crises In response to a balance-of-payments crisis the likelihood of a large re-form increases from 31 percent to 97percent The Pearson chi-square test rejectsthe null hypothesis that the distribution ofpolicy changes is independent of the occur-rence of a crisis at the 1-percent level Incontrast when a country is in a banking crisisthe likelihood of a large financial reform fallsfrom 55 percent to 26 percent and the pos-sibility of reversals (large or small) increasesfrom 23 percent to 95 percent Finally re-cessions (defined simply as negative GDPgrowth) and high inflation (defined as an an-

nual inflation rate exceeding 50 percent) in-crease the likelihood of reforms and reversals

To assess the relevance of the learning pro-cess we ask if the distribution of policy changesvaries with the level of financial liberalization ina country One might surmise that countrieswith highly repressed financial sectors are mostlikely to reform as they have the most potentialfor liberalizing This is not quite the case Wefind that countries with highly repressed finan-cial systems tend to stay that way reflected intheir high proportion of status quo observations(Table 5 first column) But after initial liberal-ization further reforms become more likelyThus reforms are more probable in an interme-diate range of liberalizationmdasheither partiallyrepressed or largely liberalized Finally whenfinancial sectors are liberalized (the fourth col-umn) reform possibilities are saturated Theliberalized state seems to be an absorbing statenone of the countries that reach the liberalizedstate undertook reversals of previous reformsThe inverse U-shaped relationship between thelevel of financial liberalization and the inci-

TABLE 4mdashFINANCIAL REFORM THE ROLE OF CRISES

(In percent)

Balance-of-payments crisis Banking crisis

No Yes No Yes

Large reform 31 97 Large reform 55 26Reform 152 158 Reform 158 130Status quo 787 705 Status quo 764 748Reversal 31 32 Reversal 23 78Large reversal 00 08 Large reversal 00 17

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1695 Pearson Chi-sq 1540

Prob 000 Prob 000

RecessionHigh (50)

inflation

No Yes No Yes

Large reform 51 49 Large reform 48 76Reform 149 186 Reform 156 141Status quo 771 696 Status quo 769 707Reversal 28 49 Reversal 28 54Large reversal 00 20 Large reversal 00 22

Total 1000 1000 Total 1000 1000Pearson Chi-sq 879 Pearson Chi-sq 1022

Prob 007 Prob 004

74 THE AMERICAN ECONOMIC REVIEW MARCH 2005

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

continuing incentive to push for further finan-cial liberalization

In summary reform may occur under a richset of conditions raising the challenge of sort-ing out the relative importance of the variousstimulating factors At the same time empiricalconclusions from the case studies on the polit-ical economy of reform and the limited numberof econometric analyses are ambiguous reflect-ing not only the genuine ambiguity in the theoryof reform but also the multifaceted nature ofreform the challenge in identifying the occur-rence and timing of reforms and the furtherdifficulty in defining conditioning events suchas crises By using a more tightly specifiedmeasure of reform than has been available in across-country setting and by paying greater at-tention to the timing of reforms and to theevents that may lead up to them we allow forthe possibility of obtaining more precise findings

III Reform Determinants Bivariate Relationships

The bivariate relationships presented in thissection have the benefit of greater transparency

than the multivariate results in Section IVwhich corroborate these findings Consider firstthe shocks that dislodge the status quo9 Duringan incumbentrsquos first year in office (as identifiedin the World Bankrsquos Database of Political In-stitutions) the proportion of status quo obser-vations drops from 78 percent to 70 percent anda Pearson chi-square test rejects the null hypoth-esis that the rows and columns are independent(Table 3 upper-left panel)10 The likelihood ofreform especially large reforms increaseshowever reversals are also more frequent dur-ing the first year in office Change then is morelikely during the first year in office supporting

9 See the Data Appendix for definitions of the indepen-dent variables used in this paper

10 The standard Pearson chi-square test statistic may beinaccurate if some of the cell frequencies are small Yatesrsquoscorrection is an adjustment to the chi-square when appliedto tables with one or more cells with frequencies less thanfive This correction also referred to as continuity correc-tion is conservative in the sense of making it more difficultto establish significance Throughout this paper we use thismore conservative continuity-corrected Pearson chi-squaretest statistic

TABLE 3mdashFINANCIAL REFORM THE ROLE OF POLITICAL CONDITIONS AND EXTERNAL INFLUENCES

(In percent)

First year in officeHigh world interest

rates

No Yes No Yes

Large reform 39 98 Large reform 52 48Reform 154 153 Reform 170 110Status quo 777 699 Status quo 751 791Reversal 30 37 Reversal 25 48Large reversal 00 12 Large reversal 02 05

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1252 Pearson Chi-sq 538

Prob 001 Prob 025

IMF program

No Yes

Large reform 46 66Reform 144 183Status quo 772 732Reversal 36 19Large reversal 03 00

Total 1000 1000Pearson Chi-sq 342

Prob 049

73VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

the opportunistic politician theory and the im-portance of the electoral cycle Though chi-square statistics are not significant high USinterest rates (when the US Treasury Bill rateis in the top quartile) are associated with lowerreform and higher reversal likelihood (upper-right panel of Table 3) and IMF programs ap-pear to have a positive reform bias (Table3 lower-left panel)

Table 4 relates financial reform to differenttypes of crises In response to a balance-of-payments crisis the likelihood of a large re-form increases from 31 percent to 97percent The Pearson chi-square test rejectsthe null hypothesis that the distribution ofpolicy changes is independent of the occur-rence of a crisis at the 1-percent level Incontrast when a country is in a banking crisisthe likelihood of a large financial reform fallsfrom 55 percent to 26 percent and the pos-sibility of reversals (large or small) increasesfrom 23 percent to 95 percent Finally re-cessions (defined simply as negative GDPgrowth) and high inflation (defined as an an-

nual inflation rate exceeding 50 percent) in-crease the likelihood of reforms and reversals

To assess the relevance of the learning pro-cess we ask if the distribution of policy changesvaries with the level of financial liberalization ina country One might surmise that countrieswith highly repressed financial sectors are mostlikely to reform as they have the most potentialfor liberalizing This is not quite the case Wefind that countries with highly repressed finan-cial systems tend to stay that way reflected intheir high proportion of status quo observations(Table 5 first column) But after initial liberal-ization further reforms become more likelyThus reforms are more probable in an interme-diate range of liberalizationmdasheither partiallyrepressed or largely liberalized Finally whenfinancial sectors are liberalized (the fourth col-umn) reform possibilities are saturated Theliberalized state seems to be an absorbing statenone of the countries that reach the liberalizedstate undertook reversals of previous reformsThe inverse U-shaped relationship between thelevel of financial liberalization and the inci-

TABLE 4mdashFINANCIAL REFORM THE ROLE OF CRISES

(In percent)

Balance-of-payments crisis Banking crisis

No Yes No Yes

Large reform 31 97 Large reform 55 26Reform 152 158 Reform 158 130Status quo 787 705 Status quo 764 748Reversal 31 32 Reversal 23 78Large reversal 00 08 Large reversal 00 17

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1695 Pearson Chi-sq 1540

Prob 000 Prob 000

RecessionHigh (50)

inflation

No Yes No Yes

Large reform 51 49 Large reform 48 76Reform 149 186 Reform 156 141Status quo 771 696 Status quo 769 707Reversal 28 49 Reversal 28 54Large reversal 00 20 Large reversal 00 22

Total 1000 1000 Total 1000 1000Pearson Chi-sq 879 Pearson Chi-sq 1022

Prob 007 Prob 004

74 THE AMERICAN ECONOMIC REVIEW MARCH 2005

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

the opportunistic politician theory and the im-portance of the electoral cycle Though chi-square statistics are not significant high USinterest rates (when the US Treasury Bill rateis in the top quartile) are associated with lowerreform and higher reversal likelihood (upper-right panel of Table 3) and IMF programs ap-pear to have a positive reform bias (Table3 lower-left panel)

Table 4 relates financial reform to differenttypes of crises In response to a balance-of-payments crisis the likelihood of a large re-form increases from 31 percent to 97percent The Pearson chi-square test rejectsthe null hypothesis that the distribution ofpolicy changes is independent of the occur-rence of a crisis at the 1-percent level Incontrast when a country is in a banking crisisthe likelihood of a large financial reform fallsfrom 55 percent to 26 percent and the pos-sibility of reversals (large or small) increasesfrom 23 percent to 95 percent Finally re-cessions (defined simply as negative GDPgrowth) and high inflation (defined as an an-

nual inflation rate exceeding 50 percent) in-crease the likelihood of reforms and reversals

To assess the relevance of the learning pro-cess we ask if the distribution of policy changesvaries with the level of financial liberalization ina country One might surmise that countrieswith highly repressed financial sectors are mostlikely to reform as they have the most potentialfor liberalizing This is not quite the case Wefind that countries with highly repressed finan-cial systems tend to stay that way reflected intheir high proportion of status quo observations(Table 5 first column) But after initial liberal-ization further reforms become more likelyThus reforms are more probable in an interme-diate range of liberalizationmdasheither partiallyrepressed or largely liberalized Finally whenfinancial sectors are liberalized (the fourth col-umn) reform possibilities are saturated Theliberalized state seems to be an absorbing statenone of the countries that reach the liberalizedstate undertook reversals of previous reformsThe inverse U-shaped relationship between thelevel of financial liberalization and the inci-

TABLE 4mdashFINANCIAL REFORM THE ROLE OF CRISES

(In percent)

Balance-of-payments crisis Banking crisis

No Yes No Yes

Large reform 31 97 Large reform 55 26Reform 152 158 Reform 158 130Status quo 787 705 Status quo 764 748Reversal 31 32 Reversal 23 78Large reversal 00 08 Large reversal 00 17

Total 1000 1000 Total 1000 1000Pearson Chi-sq 1695 Pearson Chi-sq 1540

Prob 000 Prob 000

RecessionHigh (50)

inflation

No Yes No Yes

Large reform 51 49 Large reform 48 76Reform 149 186 Reform 156 141Status quo 771 696 Status quo 769 707Reversal 28 49 Reversal 28 54Large reversal 00 20 Large reversal 00 22

Total 1000 1000 Total 1000 1000Pearson Chi-sq 879 Pearson Chi-sq 1022

Prob 007 Prob 004

74 THE AMERICAN ECONOMIC REVIEW MARCH 2005

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

dence of reform is consistent with the idea thatldquolearningrdquo creates a self-sustaining dynamic inthe reform process

Finally with respect to ideology and struc-ture we find left-wing governments are no lessreform-oriented than right-wing governments(Table 6 upper-left panel)11 In fact left-wing

governments are slightly more likely to under-take large reforms while the right-wing govern-ments are slightly more likely to reverseprevious reforms in support of Cukierman andTommasi (1998) Different regime typesmdashpres-idential versus parliamentary forms of govern-mentmdashalso do not have a significant effect on

11 The orientation measure is taken from the WorldBankrsquos (2001) Database of Political Institutions the

Data Appendix contains a description of their ideologymeasure

TABLE 6mdashPOLICIES IDEOLOGY AND STRUCTURE

(In percent)

Political orientation System of government

LeftCenterother Right Parliamentary Presidential

Large reform 66 50 44 Large reform 56 48Reform 155 136 171 Reform 168 147Status quo 751 788 742 Status quo 743 770Reversal 28 20 44 Reversal 32 30Large reversal 00 07 00 Large reversal 00 05

Total 1000 1000 1000 Total 1000 1000Pearson Chi-sq 518 Pearson Chi-sq 117

Prob 074 Prob 088

Trade openness

Firstquartile

Secondquartile

Thirdquartile

Fourthquartile

Large reform 30 69 45 60Reform 156 162 169 129Status quo 774 735 766 771Reversal 35 34 15 40Large reversal 05 00 05 00

Total 1000 1000 1000 1000Pearson Chi-sq 500

Prob 096

TABLE 5mdashPOLICIES AND THE CURRENT STATE OF LIBERALIZATION

(In percent)

Current state of liberalization

Fully repressedPartiallyrepressed

Largelyliberalized Liberalized

Large reform 53 79 46 00Reform 80 219 224 87Status quo 859 641 672 913Reversal 08 58 52 00Large reversal 00 04 06 00

Total 1000 1000 1000 1000Pearson Chi-sq 5854 Prob 000

75VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

financial policy choices as can be seen in theupper-right panel of Table 6 Last we considerthe influence of openness to trade measured asthe sum of imports and exports relative to GDPWe find no significant relationship betweenopenness and financial policy choice

IV Reform Determinants Multivariate Analysis

Recall that our liberalization measure sums thesix components of financial liberalization eachranging from 0 to 3 and hence the overall mea-sure takes on integer values between 0 and 18 Tofacilitate interpretation of the regressions we di-vide the overall liberalization measure by 18 to getan index FLit which ranges from 0 to 1 with 0corresponding to a completely repressed financialsector and 1 corresponding to a fully liberalizedfinancial sector Our dependent variable is FLitwhich measures policy changes Given the dis-crete ordinal nature of the dependent variable weuse the ordered logit method for our estimation(see William H Greene 2000 for details)12 Theordered logit extends the traditional logit to allowfor multiple discrete outcomes that can be ranked(as distinct from a multinomial logit used foranalyzing multiple outcomes that cannot beranked)

A Benchmark Specification

As discussed in Section II the status quomay be altered by shocks or events that alterthe power balance among competing groupsdomestic and regional learning processes orideological or structural factors To modeldomestic ldquolearningrdquo we specify a simple re-duced-form dynamic process Policy changeis affected by the difference between the de-sired level of financial liberalization FLitand the current level of financial liberaliza-tion FLit1 so that

(1) FLit FLit FLit 1 it

The adjustment factor is a measure of thestatus quo bias the lower is the greater the

status quo bias Since FLit is not observable webegin in our benchmark model with the assump-tion that the desired level of financial liberaliza-tion is FLit 1 This assumption implies thatfinancial liberalization is regarded by policy-makers as a welfare-enhancing and achievableldquoglobal normrdquo Country-specific measures ofdesired liberalization are explored in the nextsection Second the adjustment factor islikely to be time-varying allowing for the pos-sibility of learning Following the theoreticalliterature we assume that the resistance toreform is a function of the state of liberaliza-tion ie 1 FLit113 The presumption isthat 1 0 so that status quo bias is highestwhen financial sectors are repressed and the biasdeclines as the sector is liberalized Such adynamic would occur for example in a multi-stage version of the Fernandez-Rodrik modelwhere earlier reforms help identify winners andlosers It is also consistent with a strengtheningof ldquooutsiderdquo groupsrsquo positions relative to in-cumbents and with the need to build technicaland managerial expertise in reform implemen-tation We can thus rewrite the above equationas

(2) FLit 1 FLit 1 1 FLit 1 it

We also want to test for the possibility ofregional diffusion If such an influence wereimportant countries within a region would beinduced to catch up with the highest level ofliberalization reached within the region (the re-gional ldquonormrdquo) either due to a reduction inuncertainty regarding the benefits of reform ordue to competition for external capital flowsThe larger the gap between the maximum levelof liberalization achieved in the region (REG_FLit1) and the level of a countryrsquos state ofliberalization (FLit1) the higher would be theprobability of further liberalization

(3) FLit 1 FLit 11 FLit 1

2REG_FLit 1 FLit 1 it

12 Estimation using ordered probit produces similar re-sults The degree of excess of our dependent variable FLit

is 2281482 3 74 suggesting that the use of the(leptokurtic) logistic distribution is more appropriate

13 A more general specification 0 1 FLit1 was also considered equivalent to adding (1 FLit1) asan additional regressor This additional term was not sig-nificant and did not affect any of the results so in whatfollows we use the more parsimonious specification

76 THE AMERICAN ECONOMIC REVIEW MARCH 2005

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

Finally various shocks can dislodge the sta-tus quo and ideology and structure can influ-ence the speed of reforms We include in ourempirical analyses a set of variables reflectingthese influences (SHOCKSit IDEOLOGYit andSTRUCTUREit respectively) This implies thefollowing specification

(4) FLit 1FLit 11 FLit 1

2REG_FLit 1 FLit 1

3SHOCKSit 4IDEOLOGYit

5STRUCTUREit it

In the category of ldquoshocksrdquo we include dum-mies as discussed in Section II for balance-of-payments crises (BOPit) banking crises(BANKit) recessions (RECESSIONit) and high-inflation periods (HINFLit)

14 For the politicalvariables we examine the honeymoon hypoth-esis by including a dummy variable indicatingthe incumbent executiversquos first year in office(FIRSTYEARit) The influence of internationalfinancial institutions on policy reform is proxiedby an IMF program dummy (IMFit) And toexplore the influence of global factors we in-clude international interest rates (USINTt) Forthe political orientation to reform we includedummy variables for left-wing and right-winggovernments (LEFTit RIGHTit) centrist gov-ernments are the omitted category The struc-tural variable included here is trade openness(OPENit) in the sensitivity analysis below weconsider additional structural variables that maybe relevant but are effectively time-invariantsuch as legal origin and the system of govern-ment All of these variables enter the regressioncontemporaneously except for banking and bal-ance-of-payments crises dummy variableswhich take the value 1 if a crisis occurred withinthe past two years since these may have pro-longed effects (the results are robust to chang-ing the time horizon for crises) In our

discussion we also summarize results obtainedby interacting the ideology and structural vari-ables with the ldquoshockrdquo variables on the premisethat ideology and structure may indirectly influ-ence the speed of response following shocks

Results in Table 7 are presented without andwith country fixed effects Columns 1 and 4show the result of regressing FLit on the do-mestic learning dynamic FLit1(1 FLit1)and on the regional diffusion variable REG_FLit1 FLit1 The coefficient on FLit1(1 FLit1) is positive and significant at the1-percent level confirming the conjecture thatstatus quo bias decreases as financial liberaliza-tion increases and verifying the inverseU-shaped relationship between policy changeand the level of liberalization suggested in Ta-ble 5 This relationship is consistent with sev-eral channels through which initial reformsincrease the incentives and pressures for furtherreforms including a better assessment of thevalue and distribution of reforms and greatervoice for ldquooutsidersrdquo who as incipient insidershave more say in the policymaking process How-ever it is possible that some steps in the multi-stage process mechanically follow each other15

The crisisadversity dummies are added tothe regression in columns 2 and 5 Consistentwith Table 4 the coefficient on the balance-of-payments crisis dummy variable is positive andstatistically significant suggesting that thesecrises are an impetus to reform In contrastfinancial liberalization is typically set back fol-lowing banking crises as indicated by the neg-ative and significant coefficient on the bankingcrisis dummy Thus greater government controlof the financial sector appears to be a commontemporary response to banking crises possiblyto prevent a collapse of confidence Of interestalso is the policy outcome following ldquotwin

14 Of the 875 observations in our sample 120 obser-vations are associated with banking crises Of these 58occur when there is no balance-of-payments crisis and 62overlap with balance-of-payments crises Similarly thebalance of payments crisis dummy takes the value 1 for260 observations

15 If the first reform step may already entail plannedfurther steps which unroll according to a schedule subse-quent reforms would not be affected by such variables ascrisis occurrence regional diffusion and how far alongprevious reforms have progressed To examine this possi-bility we repeated the estimation after dropping initialreforms (reforms that occurred from a state of full repres-sion) and found that the full sample results continue to holdMoreover interactive results associated with Table 9 belowshow that the effects of various determinants evolve over thecourse of the reform process which prima facie also arguesagainst a purely mechanical evolution of reforms

77VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

crisesrdquo when balance-of-payments and bankingcrises coincide The negative coefficient on thebanking crisis dummy is twice as large as thecoefficient on the balance-of-payments crisisdummy implying that during twin crises re-forms are unlikely and reversals become a pos-sibility16 Finally the effects of the recessionand high-inflation dummy variables are insig-nificant possibly because as Table 4 showedboth reforms and reversals become morelikely17

The coefficient on the dummy variable for thefirst year in office is positive but not significant(columns 3 and 6) which possibly results fromthe increased likelihood of reform being (par-tially) offset by the increased likelihood of re-versals as documented in Table 3 The IMFprogram dummy has a positive coefficientindicating movement toward reform during pe-riods of IMF programs It is marginally signif-icant when country dummies are not includedbut becomes insignificant when country dum-mies are added suggesting that the factors thatlead to an IMF program also hasten financialreform In line with Bartolini and Drazen(1997) a rise in US interest rates is seen toslow down the pace of financial sector liberal-

16 The F-test for the sum of the balance-of-paymentscrisis and banking crisis dummies has a p-value of 013 Anadditional twin crisis dummymdashallowing for nonlinear ef-fects when the two crises coincidemdashis not significant on itsown however an F-test for the sum of the balance-or-payments banking and twin crisis dummies has a negativesign and a p-value of 003

17 Reversals appear to become more likely under ldquose-vererdquo contractions when GDP declined by 5 percent or

more once again suggesting that the severity of a crisis mayoverwhelm reform efforts However this result was notrobust to alternative specifications

TABLE 7mdashORDERED LOGIT ESTIMATES BENCHMARK SPECIFICATION (EQUATION 4)

Without country fixed effects With country fixed effects

FLit1 (1 FLit1) 4001 4652 4188 6316 6932 6295(414) (481) (425) (418) (461) (399)

REG_FLit1 FLit1 0842 0897 0993 1940 1841 2324(339) (301) (316) (0695) (232) (280)

BOPit 0526 0439 0568 0488(267) (231) (226) (201)

BANKit 1025 0993 1022 0965(280) (275) (278) (269)

RECESSIONit 0071 0056 0076 0059(021) (017) (021) (016)

HINFLit 0161 0264 0355 0343(040) (066) (0645) (053)

FIRSTYEARit 0194 0242(084) (089)

IMFit 0326 0324(175) (124)

USINTt 0066 0089(172) (203)

LEFTit 0242 0072(100) (020)

RIGHTit 0169 0196(089) (058)

OPENit 0001 0006(105) (0009)

Log L 76266 75205 74720 74910 73893 73411Wald test of joint

significance (p-value) 000 000 000 000 000 000Number of observations 805 805 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index FLit Robust t-statistics are in parenthesesadjusted for clustering by country denotes significance at the 1-percent level denotes significance at the 5-percentlevel denotes significance at the 10-percent level

78 THE AMERICAN ECONOMIC REVIEW MARCH 2005

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

ization Not surprisingly since US interestrates vary only over time and not across coun-tries their effect is seen to be stronger when thewithin-country variation is isolated in the fixed-effects regression

Finally consider the ideology and structurevariables that display some variation over time(time-invariant factors are considered in thesensitivity analysis) The coefficient on the left-wing dummy variable is larger than that on theright-wing dummy variable implying that left-wing governments tend to reform more thanright-wing governments However the resultsindicate no statistical difference across partyideologiesmdasha somewhat less spectacular resultthan that proposed by Cukierman and Tommasi(1998) but impressive and important neverthe-less Last a countryrsquos openness to trade as mea-sured by the sum of imports and exports relative toGDP is not significant in these regressions

Interacting the ideology and structural vari-ables with the ldquoshockrdquo variables did not produceany additional significant results (and are there-fore not reported here) Coefficient estimateswere more positive for left-wing governmentsduring balance-of-payments crises and morenegative for right-wing governments duringbanking crises but as in the uninteracted casethese differences were not significant Also Ra-jan and Zingales (2003) argue that it is thecombination of trade openness and availabilityof foreign capital that makes incumbents morewilling to liberalize the financial sector To cap-ture this idea we interacted OPENit with USINTt(the latter proxying for the availability of foreigncapital) but the results remained insignificant

The coefficient estimates in Table 7 do notgive the marginal effects of the right-hand sidevariables on the probabilities of reform rever-sal and status quo These marginal effects onprobabilities18 show that a balance-of-paymentscrisis increases the likelihood of reform by 8

percentage points a banking crisis lowers it by12 percentage points An IMF program in-creases reform likelihood by 5 percentagepoints When the regional reform leader liber-alizes by 01667 (equivalent to fully liberalizingone of the six dimensions) the likelihood ofreform increases by 6 percentage points

B Alternative Specifications

Two important assumptions guided thebenchmark empirical specification We as-sumed that the desired level of financial liber-alization is full liberalization and the speed ofadjustment to the desired level of liberalizationis a function only of the current level of liber-alization We examine now the implications ofrelaxing both assumptions The results reportedabove remain robust Interpretation is enhancedhowever since the various interaction termsintroduced in these more complex specificationssuggest ranges of the state of financial liberal-ization where particular influences may be sig-nificant even though they are not seen to besignificant on average

First the desired level of liberalization neednot necessarily equal 1 (full liberalization) butmay equal some constant 0 c 1 in whichcase the coefficients on FLit1 and FLit1

2 arenow no longer constrained to be equal Thisimplies the following specification

(5) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4SHOCKSit 5IDEOLOGYit

6STRUCTUREit it

where 1 is expected to be positive and 2 isexpected to be negative Testing whether 1 2 is equivalent to testing the assumption thatFLit 1 Alternatively the desired level offinancial liberalization could increase with acountryrsquos level of economic development Less-developed countries tend to have weaker insti-tutional capacity that limits their ability toundertake far-reaching reform also at lowerlevels of income governments may perceivemore opportunities to channel credit toward

18 The procedure for calculating the marginal effect ofthe RHS variables on reform probabilities is based onGreene (2000) For dummy variables this is calculated asthe change in probability if the dummy variable goes from0 to 1 For REG_FLit1 rather than calculate the effect ofa one-unit change (ie the regional leader moving from fullrepression to full liberalization) which is too large to bemeaningful we instead evaluate the effect of a change of16 or 01667 equivalent to fully liberalizing one of the sixdimensions

79VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

sectors that can generate positive externalitiesThis would suggest FLit a bYit where Yitis a measure of economic development andwould imply the following specification

(6) FLit 1 FLit 1 2 FLit 12

3FLit 1 Yit

4REG_FLit 1 FLit 1

5SHOCKSit 6IDEOLOGYit

7STRUCTUREit it

where 1 and 3 are expected to be positive and2 is expected to be negative The measure of

the level of development used is GDP per capitain PPP terms from the Penn World Tables

The estimation results for specifications de-scribed by (5) and (6) are reported in Table8 again with and without fixed effects Theevidence suggests that the ldquodesiredrdquo level offinancial liberalization rises with a countryrsquos percapita income The main results from the pre-vious section are preserved in the alternativespecifications namely the inverse U-shaped re-lationship between FLit and FLit1 the pos-itive and negative effects of BOPit and BANKitrespectively and the influence of world interestrates The term representing the regional gapremains positive in all estimations and signifi-cant in two of them Once again the IMFdummy is significant without country fixed ef-

TABLE 8mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATIONS 5 AND 6)

Without country fixedeffects With country fixed effects

FLit1 4161 4314 6130 6662(427) (443) (400) (421)

(FLit1)2 4324 6091 6701 9763(411) (441) (328) (370)

FLit1 Yit1 0103 0234(241) (240)

REG_FLit1 FLit1 0896 0568 1902 2070(210) (117) (147) (167)

BOPit 0440 0489 0471 0454(231) (254) (202) (195)

BANKit 0988 0980 0942 1014(275) (274) (275) (295)

RECESSIONit 0043 0029 0060 0035(013) (009) (016) (009)

HINFLit 0268 0215 0334 0429(068) (052) (052) (068)

FIRSTYEARit 0194 0153 0238 0250(084) (067) (087) (092)

IMFit 0312 0400 0331 0370(161) (201) (127) (139)

USINTt 0067 0071 0093 0089(175) (183) (211) (204)

LEFTit 0251 0149 0031 0092(105) (066) (009) (026)

RIGHTit 0187 0183 0144 0091(095) (098) (043) (026)

OPENit 0001 00001 0007 0010(084) (011) (0780) (1020)

Log L 74713 74494 73391 73011Wald test of joint

significance (p-value)000 000 000 000

Number of observations 805 805 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robustt-statistics are in parentheses adjusted for clustering by country denotes significance atthe 1-percent level denotes significance at the 5-percent level denotes significance at the10-percent level

80 THE AMERICAN ECONOMIC REVIEW MARCH 2005

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

fects but becomes insignificant when fixed ef-fects are included All other variables remaininsignificant as before

Next since measures the degree of statusquo bias the shock ideology and structurevariables could enter via their effect on ratherthan directly on FLit That is

(7) 1 FLit 1

2 REG_FLit 1 FLit 1

3SHOCKSit

4IDEOLOGYit

5STRUCTUREit

With FLit c19 we estimate the followingspecification

(8) FLit 1 FLit 1 2 FLit 12

3REG_FLit 1 FLit 1

4REG_FLit 1 FLit 1 FLit 1

5SHOCKit 6SHOCKit FLit 1

7IDEOLOGYit

8IDEOLOGYit FLit 1

9STRUCTUREit

10STRUCTUREit FLit 1 it

The inverse U-shaped relationship betweenFLit and FLit1 continues to hold (Table9) The interaction between the regional lib-eralization gap with the level of a countryrsquosliberalization is positive and significant sug-gesting that regional competitive spirit becomes

more pronounced as the level of liberalizationincreases The respective positive and negativeeffects of BOPit and BANKit on FLit remain asbefore

The dummy for the first year in office ispositive and significant at the 10-percent leveland the interaction term is negative and signif-icant at 5 percent The implication is that thefirst year in office has a positive effect on re-forms when the level of liberalization is lowbut that this effect tapers off as the level ofliberalization rises Similarly the IMF pro-gram dummy is positive and significant at the5-percent level but the coefficient on theinteraction term IMFit FLit1 is negativeand is also significant at the 5-percent levelThus the earlier ambiguity with respect to therole of IMF programs arose because theseprograms have the strongest effect on reformlikelihood in countries that are still highlyrepressed and most in need of reform but theeffect declines thereafter The additionalnoteworthy finding is the positive effect oftrade openness on the pace of reform at lowlevels of liberalization As the negative coef-ficient on the interaction term indicates thispositive effect falls away as the level of lib-eralization increases

There is no widely accepted method forassessing goodness-of-fit in ordered logitmodels (Greene 2000)20 In Table 10 wecompare the actual policy implemented withthe modelrsquos predicted policy where the pre-dictions are generated using equation (8) Wehave grouped large reversals and reversalstogether and reforms and large reforms to-gether although this still leaves the samplehighly unbalanced with reversalslarge rever-sals comprising only 4 percent of observa-tions21 Only 7 percent (2 of the 27) ofreversals are correctly predicted The two

19 The cases where FLit 1 and FL

it a bYit whichproduce similar results are available from the authors onrequest Since the world interest rate is the same acrosscountries we do not interact it with FLit1 as the interac-tion term is highly correlated (0844) with the uninteractedFLit1

20 Commonly reported measures such as McFaddenrsquospseudo-R2 do not have any interpretation for values be-tween 0 and 1

21 One can test for asymmetry between the likelihood ofreforms and reversals using the cutoff points in the orderedlogit model ie the points at which the underlying latentvariable transitions from one state to another The cutoffpoint separating reversals from status quo is significantlylarger in absolute magnitude than the one separating re-forms from the status quo

81VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

reversals that the model correctly predicts arethe most significant in our samplemdashArgentinain 1982 and Venezuela in 1994 The other

more minor reversals which the model doesnot predict appear to be related to more di-rected lending to so-called ldquopriorityrdquo sectors

TABLE 9mdashORDERED LOGIT ESTIMATES ALTERNATIVE SPECIFICATIONS (EQUATION 8)

Without country fixed effects With country fixed effects

FLit1 3824 (265) 4486 (215)[709] [471]

(FLit1)2 3644 (237) 2930 (114)

REG_FLit1 FLit1 0094 (016) 1277 (093)[471] [1290]

(REG_FLit1 FLit1) FLit1 3387 (183) 8918 (355)

BOPit 0834 (286) 0796 (189)[992] [442]

BOPit FLit1 0901 (150) 0984 (113)

BANKit 0901 (167) 1064 (180)[642] [859]

BANKit FLit1 0079 (007) 0006 (001)

RECESSIONit 0518 (112) 0555 (102)[190] [149]

RECESSIONit FLit1 1224 (138) 1185 (121)

HINFLit 0346 (070) 0415 (053)[350] [553]

HINFLit FLit1 2535 (187) 3568 (235)

FIRSTYEARit 0564 (199) 0607 (190)[454] [382]

FIRSTYEARit FLit1 1140 (183) 1041 (145)

IMFit 0752 (290) 0692 (206)[841] [473]

IMFit FLit1 1502 (223) 1762 (198)

USINTt 0073 (179) [179] 0088 (203) [203]

LEFTit 0117 (030) 0611 (115)[051] [162]

LEFTit FLit1 0661 (066) 1323 (110)

RIGHTit 0366 (120) 0151 (040)[202] [017]

RIGHTit FLit1 0397 (041) 0132 (011)

OPENit 0003 (055) 0029 (178)[132] [584]

OPENit FLit1 0005 (088) 0045 (242)

Log L 73797 71892Wald test of joint significance

(p-value) 000 000Number of observations 805 805

Notes The dependent variable is the change in the Financial Liberalization Index Robust standard errors are in parenthesesadjusted for clustering by country F-statistics for joint test of coefficient pairs in square brackets denotes significanceat the 1-percent level denotes significance at the 5-percent level denotes significance at the 10-percent level

82 THE AMERICAN ECONOMIC REVIEW MARCH 2005

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

as part of poverty alleviation efforts22 Themodel does a much better job of predictingstatus quo observations (72 percent) and re-formlarge reform episodes (62 percent)Overall the model correctly predicts 68 per-cent of observations

C Further Sensitivity Analysis

We tested for the robustness of the regionaldiffusion effect by including regional dummiesThe omitted ldquoregionalrdquo dummy was the onecorresponding to OECD member countries Thecoefficients on the regional dummies are mostlyinsignificant and our previous results are allrobust to their inclusion23 Our results are alsounchanged when we drop the four OECD coun-tries that were already highly liberalized at thestart of the sample periodmdashCanada Germanythe United Kingdom and the United States

A second fixed factor that we control for islegal origin La Porta et al (1997) find that legalorigin is a significant predictor of one measureof financial development the ratio of externallyheld equity market capitalization to GNP (seeLevine et al 2000 for similar findings) Wefind that our previous results are robust to the

inclusion of these dummies and that the legalorigin variables are not significant

We also found no significant differences be-tween presidential and parliamentary systems interms of the frequency and timing of reform Thecoefficient on the presidential system dummy isnegative suggesting a lower propensity to reformrelative to parliamentary systems but the effect isnot significant Interactions between the system ofgovernment and other variables such as balance-of-payments and banking crisis dummies werealso explored but no significant effects werefound Again our main results are robust to theinclusion of these variables

V Conclusions

In this paper we analyzed the determinants offinancial reform using a newly constructedcross-country database of financial liberaliza-tion covering 35 countries over the period1973ndash1996 Liberalization occurred as a com-bination of discrete changes and gradual ldquolearn-ingrdquo Since the episodic changes in response toshocks were not unidirectional domestic learn-ing (initial reforms raising the likelihood offurther reforms) and external learning throughobserving regional leaders were essential to thedynamic that sustained widespread reform Wereach five specific conclusions

First countries whose financial sectors werefully repressed were the ones with the strongest

22 Examples include Nepal in 1974 Malaysia in 1975and Indonesia in 1990

23 The estimation results described in this section are notshown but are available from the authors upon request

TABLE 10mdashGOODNESS OF FIT ACTUAL VERSUS PREDICTED POLICY

Actual policy

Predicted policy

Reversallarge reversal Status quo

Reformlarge reform Total

Reversallarge reversal 2 20 5 27(07)

Status quo 16 442 155 613(72)

Reformlarge reform 1 62 102 165(62)

Total 19 524 262 805(68)

Notes Numbers in parentheses are the percentage of correctly predicted observations Forexample 62 percent (102 out of 165) of reformlarge reform episodes are correctly predictedOverall (2 442 102) out of 805 or 68 percent of all observations are correctly predicted

83VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

tendency to maintain their policy stance andhence stay fully repressed Where initial re-forms occurred however and the financial sec-tor became even only partially repressed thelikelihood of further reforms increased substan-tially An interesting example is the Japanesefinancial liberalization experience which re-ceived its initial impetus from the emergence oflarge fiscal deficits in the 1970s and the need tofinance them The resultant development of thegovernment bond market created demand forreduced restrictions on the corporate bond mar-ket This led the government to liberalize thescope of commercial banksrsquo activities Thus theliberalization process was one of reforms beget-ting new ones

Second regional diffusion effects appear tohave been important a country was undergreater pressure to liberalize the further its stateof liberalization was from the regionrsquos leaderCountries within a region possess similar char-acteristics and were likely to be motivated bysimilar objectives including competition for thesame pool of international capital This compet-itive effect became stronger as the levels ofliberalization increased

Third among shocks the status quo waslikely to be alteredmdashthrough both reforms andreversalsmdashin the first year of a new govern-ment with reforms more likely when the liber-alization level was also low A decline in USinterest rates tended to induce reforms and arise in rates tended to set them back IMF pro-gram conditionality appears to have had astrong influence under conditions of relativelyhigh repression and a declining effect thereafter

Fourth crises did trigger action but differenttypes of crises had different effects Balance-of-payments crises raised reform likelihood Bank-ing crises however had the opposite effectincreasing the likelihood of reversals Reversalsfollowing banking crises arose in part from thenationalizations of banks Since banking crisesare periods of extreme banking sector fragilityit is not surprising that reforms were not pushedfurther during such periods since in the shortrun they risked further weakening franchisevalues of incumbent banks

Finally among variables representing ideol-ogy and structure only trade openness appearedrelated to the pace of reform There was noevidence that right-wing governments were

more reform-oriented than left-wing govern-ments If anything the propensity of left-winggovernments to reform was slightly higher thanfor right-wing governments although the differ-ence was not statistically significant Unchang-ing features such as the form of government andlegal systems were also not influential Tradeopenness hastened reform at low levels ofliberalization

For policymakers our results suggest thateven small reforms are potentially a large vic-tory since the reform process tends to build itsown momentum Reforms need not be all ornothing and if political conditions are such thatlarge reforms are not feasible it may be worthimplementing the feasible reforms Also policyreform becomes more likely under certain con-ditions Governments have used balance-of-payments crises in particular to push throughreforms The ldquohoneymoon periodrdquo an incum-bentrsquos first year in office may also be a periodwhen policy reform is possible However insuch fluid situationsmdashespecially during bank-ing crisesmdashpolicymakers also need to guardagainst backsliding

This paper though focused on the financialsector offers pointers for the broader literatureon the political economy of reform Our resultsreinforce some widely held conclusions butalso confirm that the ambiguities in the casestudy literature are real since events that alterthe status quo may lead to both reforms andreversals The analysis suggests that further in-sights into the reform process will be achievedby considering particular reform areas ratherthan by focusing on broad reform episodes Inturn this requires investment in the calibrationof reform efforts across countries and carefulspecification of the determinants of reformsEmpirical analysis must also allow for a dy-namic specification of the reform process Arich set of hypotheses linking reforms theirdeterminants and economic performance awaitsfurther exploration

DATA APPENDIX

The dependent variable in the paper is de-rived from the financial liberalization databaseand was described in detail in the paper Belowwe describe the sources used for and the trans-formations of the independent variables

84 THE AMERICAN ECONOMIC REVIEW MARCH 2005

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

The crisis variables are defined as followsThe balance-of-payments crisis variable (BOPit)and the banking crisis variable (BANKit) arebased on the crises identified in Michael DBordo et al (2001) As described in that paper(p 4) a balance-of-payments crisis is identifiedby ldquoa forced change in parity abandonment of apegged exchange rate or an international res-cuerdquo or if an index of exchange market pressure(a weighted average of exchange rate reserveand interest rate changes) exceeds a criticalthreshold of one and a half standard deviationsabove its mean Banking crises are identified byperiods of ldquofinancial distress resulting in theerosion of most or all of aggregate bankingsystem capitalrdquo Because both types of crisiscan be protracted the dummy variables BOPitand BANKit are set equal to 1 if a balance-of-payments or banking crisis respectively hasoccurred within the past two years Finally therecession dummy variable RECESSIONit is de-fined as a year where annual real GDP growth isnegative and the high inflation dummy HINFLit isdefined as a year in which annual inflation exceeds50 percent Both are based on data from the IMFrsquosInternational Financial Statistics database

The political variables are defined as followsThe first year in office dummy FIRSTYEARit is

based on the YRSOFFC variable in the WorldBankrsquos (2001) Database of Political Institu-tions The political orientation variablesLEFTit RIGHTit and CENTERit were takenfrom the same database The ideology mea-sure in the Database of Political Institutionsdesignates party orientation based on thepresence of certain terms in the party name ordescription Those named or described asldquoconservativerdquo ldquoChristian Democraticrdquo orldquoright-wingrdquo are classified in one group thosedescribed as ldquocentristrdquo are a second groupand those named or described as ldquocommu-nistrdquo ldquosocialistrdquo ldquoSocial Democraticrdquo orldquoleft-wingrdquo are a third group Those that can-not be classified into these three categoriesare listed as ldquootherrdquo

The IMF program dummy variable IMFitwas constructed using the program dates fromthe History of Lending Arrangements reportedby the IMFrsquos Finance Department and availablethrough the IMF Web site (wwwimforg) Theworld interest rate is the US Treasury Bill rateas reported in the IMFrsquos International FinancialStatistics Finally to measure the level of eco-nomic development Yit we use GDP per capitain PPP terms from the Penn World Tables ofHeston et al (1995)

85VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

TA

BL

EA

1mdash

TH

EFI

NA

NC

IAL

LIB

ER

AL

IZA

TIO

NIN

DE

XFO

R36

EC

ON

OM

IES

1973

ndash199

6(0

F

ull

Rep

ress

ion

18

Ful

lL

iber

aliz

atio

n)

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

Eas

tA

sia

Indo

nesi

a1

11

11

11

11

14

44

44

89

89

1010

1010

11K

orea

00

00

00

00

36

67

89

99

88

1010

1010

1010

Mal

aysi

a7

75

66

99

1010

1010

109

912

1213

1313

1313

1212

12Ph

ilipp

ines

33

33

33

36

66

88

88

88

99

910

1010

1111

Sing

apor

e15

1515

1515

1616

1616

1616

1616

1616

1616

1616

1616

1616

16T

aiw

an0

00

00

00

00

00

00

01

14

44

66

66

6T

haila

nd2

22

22

22

55

55

55

55

59

1010

1213

1313

13So

uth

Asi

aB

angl

ades

h0

00

00

00

00

22

22

22

23

46

77

87

7In

dia

00

00

00

00

00

00

00

00

00

14

66

66

Nep

al1

00

00

00

00

01

11

22

24

44

44

66

6Pa

kist

an2

20

00

00

00

00

00

00

00

14

55

810

10Sr

iL

anka

00

00

16

67

77

77

77

78

77

77

89

99

Lat

inA

mer

ica

Arg

entin

a0

00

011

1111

1111

33

33

35

66

66

1212

1212

12B

razi

l1

11

33

31

12

22

22

22

45

56

66

67

8C

hile

08

911

1112

1414

1413

1213

1515

1515

1515

1515

1515

1515

Col

ombi

a3

43

33

33

44

33

33

33

33

410

109

99

9M

exic

o3

44

44

44

44

22

22

22

39

912

1212

1212

13Pe

ru0

00

00

00

00

00

00

00

00

05

1113

1313

13V

enez

uela

22

22

22

22

22

22

22

22

44

88

83

38

Afr

ica

and

the

Mid

dle

Eas

tE

gypt

11

11

11

11

11

11

11

11

11

99

99

910

Gha

na0

00

00

00

00

00

00

02

34

45

56

78

8Is

rael

55

55

77

55

55

33

33

1010

1011

1111

1212

1212

Mor

occo

11

11

11

11

11

11

11

11

22

33

78

811

Sout

hA

fric

a7

77

55

55

1111

1113

1312

1212

1212

1314

1414

1417

17Z

imba

bwe

22

22

22

22

22

22

22

22

25

55

68

88

OE

CD

Cou

ntri

esA

ustr

alia

00

00

00

00

13

36

99

1113

1313

1314

1417

1717

Can

ada

1515

1515

1515

1516

1616

1616

1616

1616

1616

1718

1818

1818

Fran

ce5

55

55

55

55

44

79

1213

1313

1313

1314

1414

14U

nite

dK

ingd

om12

1212

1212

1214

1517

1717

1717

1818

1818

1818

1818

1818

18G

erm

any

1616

1616

1616

1616

1616

1616

1616

1616

1616

1616

1717

1717

Ital

y5

56

66

66

66

68

88

66

89

1212

1315

1515

15Ja

pan

44

44

44

67

77

79

1010

1010

1010

1111

1313

1414

New

Zea

land

22

24

44

44

22

210

1314

1515

1616

1618

1818

1818

Tur

key

11

11

11

16

66

55

57

89

1312

1212

1212

1212

Uni

ted

Stat

es13

1414

1414

1414

1515

1616

1616

1616

1616

1616

1616

1717

17

REFERENCES

Alesina Alberto and Roubini Nouriel ldquoPoliticalCycles in OECD Economiesrdquo Review ofEconomic Studies 1992 59(4) pp 663ndash88

Axelrod Robert ldquoThe Dissemination of Cul-ture A Model with Local Convergence andGlobal Polarizationrdquo Journal of Conflict Res-olution 1997 41(2) pp 203ndash26

Bandiera Oriana Caprio Gerard HonohanPatrick and Schiantarelli Fabio ldquoDoes Finan-cial Reform Raise or Reduce Savingrdquo Re-view of Economics and Statistics 200082(2) pp 239ndash63

Bartolini Leonardo and Drazen Allan ldquoWhenLiberal Policies Reflect External ShocksWhat Do We Learnrdquo Journal of Interna-tional Economics 1997 42(3ndash4) pp 249ndash73

Bates Robert H and Krueger Anne O eds Po-litical and economic interactions in economicpolicy reform Evidence from eight countriesOxford Blackwell 1993

Bordo Micahel D Eichengreen Barry Klinge-biel Daniela and Martinez Peria MariaSoledad ldquoFinancial Crises Lessons from theLast 120 Yearsrdquo Economic Policy A Euro-pean Forum 2004 16(32) pp 51ndash82

Brinks Daniel M and Coppedge Michael ldquoPat-terns of Diffusion in the Third Wave ofDemocracyrdquo American Political Science As-sociation 2001

Bruno Michael and Easterly William ldquoInfla-tionrsquos Children Tales of Crises That BegetReformsrdquo American Economic Review 1996(Papers and Proceedings) 86(2) pp 213ndash17

Caprio Gerard Honohan Patrick and StiglitzJoseph E eds Financial liberalization Howfar how fast Cambridge Cambridge Uni-versity Press 2001

Cukierman Alex and Tommasi Mariano ldquoCred-ibility of Policymakers and of EconomicReformsrdquo in Federico Sturzenegger andMariano Tommasi eds The political econ-omy of reform Cambridge MA MIT Press1998 pp 329ndash47

de Brouwer Gordon and Pupphavesa Wisarneds Asia Pacific financial deregulation NewYork Routledge 1999

Demirguc-Kunt Asli and Detragiache EnricaldquoFinancial Liberalization and Financial Fra-

gilityrdquo in Gerard Caprio Patrick Honohanand Joseph E Stiglitz eds Financial liber-alization how far how fast CambridgeCambridge University Press 2001 pp 96ndash122

Drazen Allan Political economy in macroeco-nomics Princeton Princeton UniversityPress 2000

Drazen Allan and Easterly William ldquoDo CrisesInduce Reform Simple Empirical Tests ofConventional Wisdomrdquo Economics and Pol-itics 2001 13(2) pp 129ndash57

Edison Hali J and Warnock Francis E ldquoA Sim-ple Measure of the Intensity of Capital Con-trolsrdquo Journal of Empirical Finance 200310(1ndash2) pp 81ndash103

Edwards Sebastian and Steiner Roberto ldquoOnthe Crisis Hypothesis of Economic ReformColombia 1989ndash91rdquo Cuadernos de Econo-mia (Pontifical Catholic University of Chile)2000 37(112) pp 445ndash93

Fanelli Jose Maria and Medhora Rohinton edsFinancial reform in developing countriesLondon Macmillan Press Ltd 1998

Fernandez Raquel and Rodrik Dani ldquoResis-tance to Reform Status Quo Bias in the Pres-ence of Individual-Specific UncertaintyrdquoAmerican Economic Review 1991 81(5) pp1146ndash55

Greene William H Econometric analysis 5th

ed Upper Saddle River Prentice-Hall 2000Haggard Stephan and Webb Steven B ldquoWhat

Do We Know about the Political Economy ofEconomic Policy Reformrdquo World Bank Re-search Observer 1993 8(2) pp 143ndash68

Heston Alan W Summers Robert NuxollDaniel A and Aten Bettina ldquoPenn World Ta-bles Version 56rdquo Center for InternationalComparison University of Pennsylvania1995

Johnston R Barry and Sundararajan Vasude-van eds Sequencing financial sector reformsCountry experiences and issues WashingtonDC International Monetary Fund 1999

Kaminsky Graciela L and Reinhart Carmen MldquoThe Twin Crises The Causes of Bankingand Balance-of-Payments Problemsrdquo Ameri-can Economic Review 1999 89(3) pp 473ndash500

Kaminsky Graciela and Schmukler SergioldquoShort-Run Pain Long-Run Gain The Effectsof Financial Liberalizationrdquo International

87VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

REFERENCES

Alesina Alberto and Roubini Nouriel ldquoPoliticalCycles in OECD Economiesrdquo Review ofEconomic Studies 1992 59(4) pp 663ndash88

Axelrod Robert ldquoThe Dissemination of Cul-ture A Model with Local Convergence andGlobal Polarizationrdquo Journal of Conflict Res-olution 1997 41(2) pp 203ndash26

Bandiera Oriana Caprio Gerard HonohanPatrick and Schiantarelli Fabio ldquoDoes Finan-cial Reform Raise or Reduce Savingrdquo Re-view of Economics and Statistics 200082(2) pp 239ndash63

Bartolini Leonardo and Drazen Allan ldquoWhenLiberal Policies Reflect External ShocksWhat Do We Learnrdquo Journal of Interna-tional Economics 1997 42(3ndash4) pp 249ndash73

Bates Robert H and Krueger Anne O eds Po-litical and economic interactions in economicpolicy reform Evidence from eight countriesOxford Blackwell 1993

Bordo Micahel D Eichengreen Barry Klinge-biel Daniela and Martinez Peria MariaSoledad ldquoFinancial Crises Lessons from theLast 120 Yearsrdquo Economic Policy A Euro-pean Forum 2004 16(32) pp 51ndash82

Brinks Daniel M and Coppedge Michael ldquoPat-terns of Diffusion in the Third Wave ofDemocracyrdquo American Political Science As-sociation 2001

Bruno Michael and Easterly William ldquoInfla-tionrsquos Children Tales of Crises That BegetReformsrdquo American Economic Review 1996(Papers and Proceedings) 86(2) pp 213ndash17

Caprio Gerard Honohan Patrick and StiglitzJoseph E eds Financial liberalization Howfar how fast Cambridge Cambridge Uni-versity Press 2001

Cukierman Alex and Tommasi Mariano ldquoCred-ibility of Policymakers and of EconomicReformsrdquo in Federico Sturzenegger andMariano Tommasi eds The political econ-omy of reform Cambridge MA MIT Press1998 pp 329ndash47

de Brouwer Gordon and Pupphavesa Wisarneds Asia Pacific financial deregulation NewYork Routledge 1999

Demirguc-Kunt Asli and Detragiache EnricaldquoFinancial Liberalization and Financial Fra-

gilityrdquo in Gerard Caprio Patrick Honohanand Joseph E Stiglitz eds Financial liber-alization how far how fast CambridgeCambridge University Press 2001 pp 96ndash122

Drazen Allan Political economy in macroeco-nomics Princeton Princeton UniversityPress 2000

Drazen Allan and Easterly William ldquoDo CrisesInduce Reform Simple Empirical Tests ofConventional Wisdomrdquo Economics and Pol-itics 2001 13(2) pp 129ndash57

Edison Hali J and Warnock Francis E ldquoA Sim-ple Measure of the Intensity of Capital Con-trolsrdquo Journal of Empirical Finance 200310(1ndash2) pp 81ndash103

Edwards Sebastian and Steiner Roberto ldquoOnthe Crisis Hypothesis of Economic ReformColombia 1989ndash91rdquo Cuadernos de Econo-mia (Pontifical Catholic University of Chile)2000 37(112) pp 445ndash93

Fanelli Jose Maria and Medhora Rohinton edsFinancial reform in developing countriesLondon Macmillan Press Ltd 1998

Fernandez Raquel and Rodrik Dani ldquoResis-tance to Reform Status Quo Bias in the Pres-ence of Individual-Specific UncertaintyrdquoAmerican Economic Review 1991 81(5) pp1146ndash55

Greene William H Econometric analysis 5th

ed Upper Saddle River Prentice-Hall 2000Haggard Stephan and Webb Steven B ldquoWhat

Do We Know about the Political Economy ofEconomic Policy Reformrdquo World Bank Re-search Observer 1993 8(2) pp 143ndash68

Heston Alan W Summers Robert NuxollDaniel A and Aten Bettina ldquoPenn World Ta-bles Version 56rdquo Center for InternationalComparison University of Pennsylvania1995

Johnston R Barry and Sundararajan Vasude-van eds Sequencing financial sector reformsCountry experiences and issues WashingtonDC International Monetary Fund 1999

Kaminsky Graciela L and Reinhart Carmen MldquoThe Twin Crises The Causes of Bankingand Balance-of-Payments Problemsrdquo Ameri-can Economic Review 1999 89(3) pp 473ndash500

Kaminsky Graciela and Schmukler SergioldquoShort-Run Pain Long-Run Gain The Effectsof Financial Liberalizationrdquo International

87VOL 95 NO 1 ABIAD AND MODY FINANCIAL REFORM

Monetary Fund IMF Working Papers No0334 2003

Krueger Anne O Political economy of policyreform in developing countries CambridgeMA MIT Press 1993

Krueger Anne O ldquoTrade Policy and EconomicDevelopment How We Learnrdquo AmericanEconomic Review 1997 87(1) pp 1ndash22

La Porta Rafael Lopez-de-Silanes FlorenciaShleifer Andrei and Vishny Robert ldquoLegalDeterminants of External Financerdquo Journalof Finance 1997 52(3) pp 1131ndash50

Laban Raul and Sturzenegger Federico ldquoDistri-butional Conflict Financial Adaptation andDelayed Stabilizationsrdquo Economics and Pol-itics 1994a 6(3) pp 257ndash76

Laban Raul and Sturzenegger Federico ldquoFiscalConservatism as a Response to the Debt Cri-sisrdquo Journal of Development Economics1994b 45(2) pp 305ndash24

Laeven Luc ldquoDoes Financial LiberalizationReduce Financing Constraintsrdquo FinancialManagement 2003 32(1) pp 5ndash34

Levine Ross Loayza Norman and Beck Thor-sten ldquoFinancial Intermediation and GrowthCausality and Causesrdquo Journal of MonetaryEconomics 2000 46(1) pp 31ndash77

Lora Eduardo and Olivera Mauricio ldquoWhatMakes Reforms Likely Political EconomyDeterminants of Reforms in Latin AmericardquoJournal of Applied Economics 2004 7(1)pp 99ndash135

Nelson Joan M ed Economic crisis and policychoice The politics of adjustment in theThird World Princeton Princeton UniversityPress 1990

OrsquoLoughlin John Ward Michael D LofdahlCorey L Cohen Jordin S Brown David SReilly David Gleditsch Kristian S and Shin

Michael ldquoThe Diffusion of Democracyrdquo An-nals of the Association of American Geogra-phers 1998 88(4) pp 545ndash74

Persson Torsten ldquoDo Political InstitutionsShape Economic Policyrdquo Econometrica2002 70(3) pp 883ndash905

Przeworski Adam Democracy and the marketPolitical and economic reforms in EasternEurope and Latin America CambridgeCambridge University Press 1991

Quinn Dennis P ldquoDemocracy and InternationalFinancial Liberalizationrdquo Unpublished Pa-per 2000

Rajan Raghuram G and Zingales Luigi ldquoTheGreat Reversals The Politics of Financial De-velopment in the Twentieth Centuryrdquo Journalof Financial Economics 2003 69(1) pp 5ndash50

Simmons Beth A and Elkins Zachary ldquoTheGlobalization of Liberalization Policy Diffu-sion in the International Political EconomyrdquoAmerican Political Science Review 200498(1) pp 171ndash89

Teichman Judith ldquoMexico and Argentina Eco-nomic Reform and Technocratic DecisionMakingrdquo Studies in Comparative Interna-tional Development 1997 32(1) pp 31ndash55

Tornell Aaron ldquoReform from Withinrdquo NationalBureau of Economic Research Inc NBERWorking Papers No 6497 1998

Williamson John The political economy of pol-icy reform Washington DC Institute for In-ternational Economics 1994

Williamson John and Mahar Molly ldquoA Surveyof Financial Liberalizationrdquo Essays in Inter-national Finance No 221 Princeton Prince-ton University Press 1998

World Bank Database of political institutionsversion 3 Washington DC World Bank2001

88 THE AMERICAN ECONOMIC REVIEW MARCH 2005