The aftermath of stock market liberalization in emerging markets

48 Pages·2007·0.35 MB·English

Columbia University

Department of Economics
Discussion Paper Series

Income Inequality: The Aftermath of Stock Market
Liberalization in Emerging Markets

Mitali Das
Sanket Mohapatra

Discussion Paper #:0102-42

Department of Economics
Columbia University
New York, NY 10027
March 2002
Columbia University
Department of Economics Discussion Paper No. 0102-42
Income Inequality: The Aftermath of Stock Market Liberalization in Emerging Markets
Mitali Das*
Sanket Mohapatra**
March 2002

Abstract:

Early research has documented that the large scale equity market liberalizations of the
last decade led the subsequent rise in aggregate equity indices, investment booms, capital
flows and economic growth. An important and unaddressed issue is the normative
question of whether and how these reforms shifted the distribution of incomes in the
aftermath of equity market liberalization. In careful empirical analysis, we find a pattern
indicating that income share growth accrued almost wholly to the top quintile of the
income distribution at the expense of a “middle class” that we define as the three middle
quintiles of the income distribution. A surprising finding is that the lowest income share
remained effectively unchanged in the event of liberalization. These patterns are robust to
the inclusion of a wide variety of controls for global shocks, country specific factors, and
contemporaneously implemented privatization and stabilization policies.

* Corresponding author: Mitali Das, Assistant Professor, Dept. of Economics, 420 West 118th Street,
Columbia University, New York, NY 10027. Email: [email protected]. Geert Bekaert and an
anonymous referee gave us very detailed, useful suggestions that have improved both the style and content
of the paper. We also acknowledge useful conversations with Charles Calomiris, Peter Henry, Guido
Kuersteiner, Atif Mian, Roberto Perotti and Edmund Phelps. Special thanks to Peter Henry, Geert Bekaert
and Campbell Harvey for providing the liberalization dating procedure used in this paper. Part of this paper
was written when the first author was visiting the Center for Basic Research in social sciences at Harvard
whose hospitality is warmly acknowledged. Remaining errors are ours.

** Department of Economics, Columbia University, New York, NY 10027. Email: [email protected]
1. Introduction
In the latter half of the 1980s and the early years of the 1990s, the governments of over two dozen
sovereign nations began to implement a wave of major economic reforms, which included capital account
liberalization, privatization and/or a host of stabilization policies. This large-scale experiment has fuelled an
active academic and popular debate on the causes and consequences of these reforms, in part because the
aftermath of such reforms is important to nations which, to date, are considering liberalizing reforms.
Empirical evidence on the consequences of these reforms will therefore be an important tool in assessing how
best to implement similar liberalization policies in reform-minded countries.
In this context, a nascent but important body of empirical research has begun to emerge, analyzing
important questions such as the relation of capital account liberalization to (i) emerging market equity prices
(e.g., Bekaert and Harvey (2000), Kim and Singal (2000), Henry (2000a), Froot, O’Connell and Seasholes
(2000)), (ii) liquidity (Levine and Zervos (1998)), (iii) private investment (Levine and Zervos (1998), (Henry
(2000b), Bekaert and Harvey (2000)), (iv) equity flows (Bekaert, Harvey and Lumsdaine (2002), and (v)
economic growth (Bekaert, Harvey and Lundblad (2001)). This literature has found strong evidence that
suggests capital account liberalization is associated with higher equity prices, lower cost of capital,
investment booms, greater capital flows and higher growth.
To date, an important but unaddressed question in this literature is the issue of whether and how these
reforms have shifted the distribution of incomes in the reforming countries. This is an important area of
research for several reasons. For example, the finding in Bekaert, Harvey and Lundblad (2000) that average
economic growth increased after liberalization raises normative issues about the allocation of the generated
wealth. One would presumably evaluate the success of liberalizing reforms differently when average growth
uniformly raised incomes for all quantiles of the distribution, from a finding that the average growth post
liberalization was only influenced by gains to the upper tails of the income distribution. For many countries
that are still considering capital account liberalization, it is important to evaluate the benefits of market
liberalization such as investment booms relative to the potential downsides of such policy reforms, so that
future reforms may be tailored to alleviate any negative fallout from undertaking such economic reforms.
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This paper takes a step in this direction by presenting the first set of results on the association of
capital account liberalization with income inequality. In this paper, we heuristically and empirically describe
the dynamics of the shifts in income distributions in a sample of 11 countries that undertook extensive
economic reforms between 1986-1995.1 Prior to our discussion of the empirical work, we consider various
mechanisms that link capital account liberalization to income inequality. We do not intend these mechanisms
to be causal in either direction, but to provide a framework in which the finding of an empirical link between
the two variables should not necessarily be discarded as spurious.
We analyze income distribution changes by comparing the size of three income shares before and
after liberalization, conditional on a set of country-specific factors, and contemporaneous global shocks. We
study the share of GDP held by the top quintile, the lowest quintile, and a group we will henceforth refer to as
the middle class, which represents the sum of the three middle quintiles. Because we track the changes in
income shares which plausibly respond slowly to economic reforms (relative to equity prices or the dividend
yield), we analyze movements in the distribution over the “short run”, which we take as the first 2-4 years
beyond the year of the first liberalizing reform. This aspect of the analysis is discussed in more detail when
we present our methodological framework and the construction of event windows. We focus mainly on
capital account liberalization, but also control for other reforms such as privatization and stabilization policies
that were contemporaneously implemented. We will use the terms financial market liberalization, stock
market liberalization and capital account liberalization synonymously for our purposes. Regression results in
this study are given both for simple linear models as well as event-study models, which are somewhat
incongruous in this context but useful nevertheless.
The principal findings of this research indicate systematic shifts in the income distribution in the first
four years after a country’s first liberalization reform. First, the raw data indicate that in the 11 emerging
markets we consider, 9 experienced a growth in the top quintile’s share of income, and the mean share held
by the top quintile rose by 1.3 percentage points. Second, one mildly surprising finding is that there is no
discernible change in the mean income share of the lowest quintile. In the sample of 11 countries, 4

1 Data for the remaining countries are noisy and sparse. Details of the data are given in Section 2 of the
paper.
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experience declines in the lowest quintile’s income share, 7 experience growth, and the mean share held by
this group rises by 0.1 percent, which is statistically indiscernible from zero in regression analysis. This
finding supports a recent finding in Dollar and Kraay (2000) that income growth of the poor is one-for-one
with mean income growth of the population, which implies a constant income share for the poor. Based on
these two strands of evidence and a basic adding-up theorem, there must be a reduction in the aggregate
income share held by the middle class in the aftermath of capital account liberalization, and we find this to be
the case. Specifically, in 9 of the 11 emerging markets in the sample, the aggregate income share of the
middle class falls after liberalization. The raw data indicate a mean reduction of 1.45 percentage points in
their share of income.
We test this pattern in careful regression analysis, to control for variations in domestic fundamentals,
contemporaneous domestic and global business cycle effects, and country-specific effects. The regression
results indicate that the income share of the middle class is strongly negatively associated with liberalization,
and this relation persists in the presence of a wide variety of controls. In general, this finding is strongest for
the 3rd quintile but holds statistically for the 2nd and 4th quintiles as well. In contrast, there is no statistically
significant relation between liberalization and the income share of the lowest quintile in the presence of a rich
set of controls. The empirical evidence for the upper quintile points to a positive and statistically significant
relation between its income share and the event of liberalization, in accordance with the raw mean increases
in their income shares. However, for certain regression specifications this relation attenuates. Because our
regression estimates are sensitive to the choice of the regressor vector, we report a variety of results. We do
not lend any causality interpretation to our results because of the well-known problems of identification.
Instead, all of our results are presented as conditional correlations, and are open to varying interpretations,
some of which we will discuss in the context of the regression results. It is important to stress that the
described patterns hold for income shares. In the sample of emerging markets we consider, average income of
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the top quintile rose in all 11 nations, average income of the middle class as well as the lowest quintile rose in
10 of 11 nations.2
The key results obtained in this research complement, and should be viewed in the context of, some
important research that precedes this, e.g., Levine and Zervos (1998), Henry (2000a, 2000b), Bekaert and
Harvey (2000) and Bekaert, Harvey and Lundblad (2001). For instance, our finding that average middle class
income share decreased while the average income share of the upper quintile simultaneously increased,
coupled with the finding in Bekaert et. al. (2000) that mean growth increased post liberalization, indicates that
the “pie grew” upon liberalization, but that the generated wealth was disproportionately allocated to the upper
tail, suggesting a mean-increasing distributional shift. Without the result in Bekaert et. al., our finding could
not reject the hypothesis that liberalization leads greater inequality with a mean-reducing distributional shift.
The entire body of results jointly raises normative issues about capital account liberalization and the
subsequent welfare of the population, and questions of the trade-off in mean income growth and the
concomitant growth in inequality. Although the latter topics are of academic interest, they are not explicitly
discussed here, but will be addressed in future research.
To better comprehend the dynamics of these shifts in the distribution post liberalization, we
complement the regression analysis with nonparametric tests of stochastic dominance of the pre-liberalization
and post-liberalization income distributions. Logically, combining our results with that of Bekaert, Harvey
and Lundblad (2000) yields a very precise set of null hypotheses. First, patterns of income levels described in
the current research indicate that the average post-liberalization distribution of incomes should exhibit First
Order stochastic dominance (FOSD) over the pre-liberalization distribution. Similarly, SOSD should obtain.
Second, the finding that liberalization on average raises mean income growth in Bekaert et. al. (2000),
coupled with our finding that this growth appears to be driven entirely by the upper quintile, indicates that we

2 The only exception is Nigeria, where the upper quintile’s share of income after liberalization rose by 6.6
percentage points (a 13.6 percent increase), which is significantly higher than the mean increase of 1.3
percentage points in the upper quintile of all nations in the sample.
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should not reject Lorenz dominance.3 We provide formal tests of each of these hypotheses to provide a larger
context for the results of our regression analysis.
An important issue that often arises in studying emerging markets phenomena is that of dating a
country’s first liberalizing reform. In this respect, our research was aided greatly by Bekaert and Harvey (2000),
and Henry (1999, 2000a), whose work has compiled official liberalization dates on overlapping sets of the
sample of 11 liberalizing countries we consider.4 Also useful to this paper is the work of Deninger and Squire
(1996), that has assembled panel data on socioeconomic metrics for a large cross section of nations. Although
the focus of this research is on the association of financial reforms with income inequality, it is directly related
to the vast literature in growth that has studied amongst other issues, growth and income inequality (some
examples include Barro (1990), Barro and Sala-i-Martin (1995), Perotti (1996), Banerjee and Duflo (2000), and
Dollar and Kraay (2000)). This paper integrates some aspects of the growth research into studying emerging
markets phenomena, by exploring income inequality in the aftermath of stock market liberalization.
We will focus on the share of income owned by the jth quintile as the dependent variable for the
greater part of our empirical analysis (where j=l represents the lowest, j=h represents the highest quintile and,
aggregating the three middle quintiles yields a “middle class” with j=m). One might consider studying the
variation in the Gini coefficient of inequality to analyze income distributions pre- and post-liberalization; one
drawback of this measure, however, is its inability to distinguish between distributions that are unequal in
very different ways, e.g., thick-tailed at the upper end, versus thick-tailed at the lower. Furthermore, income
shares are the relevant variable to analyze in studying relative gains, and in inferring the process of resource
allocation in the liberalizing nation. Normative analyses about the welfare of the middle class whose income

3 Lorenz dominance, or mean-normalized second order stochastic dominance (SOSD) of income distribution
y over income distribution y implies that any social welfare function that is increasing and concave in
1 2
income will record higher levels of welfare in y than in y ; see Shorrocks (1983) or Litchfield (1999).
1 2
4 As a referee has pointed out to us, the issue of dating liberalizing events is a somewhat unsettled matter in
the literature. Bekaert and Harvey (2000) and Henry (2000a) are some of the primary sources, and Kim and
Singal (2000) is another. To limit the discrepancies that arise from using multiple sources, we have used data
from Bekaert and Harvey (2000) and supplemented these with data from Henry (2000a) for those nations not
covered in the former. To verify the robustness of our results, we have re-estimated all models and reproduced
the figures with data from Kim and Singal (2000). This analysis has revealed noticeable differences in only
the individual country effects, and made the estimation less precise due to a much smaller set of nations in
Kim/Singal (only 6 nations in their data set have corresponding income shares). The graphs, and alternative
dates, are available upon request from us.
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share falls in the event of capital account liberalization must therefore be tempered to allow for the possibility
that the level of income in the middle class rises after liberalization. As indicated earlier, middle class income
increased contemporaneously with the decrease in their share of national income in 10 of the 11 nations in our
sample of liberalizing nations.
The remainder of the paper is organized as follows. In Section 2 we discuss the sample of emerging
market nations in our study, provide some preliminary findings, and describe various mechanisms that link
capital account liberalization with the observed changes in income shares. Section 3 describes our empirical
methodology; results from both standard regression analysis and event study models are reported here. In
Section 4, we discuss tests of stochastic dominance and Lorenz dominance, then describe the findings of our
tests. Section 5 considers whether it is possible to give a causality interpretation to our findings. Conclusions
follow. An appendix details the data construction of this study, and the construction of some of our test
statistics.
2. Capital Account Liberalization and Income Inequality
A. Sample of Liberalizing and Non-Liberalizing Nations
Listed in Table I, our panel data consist of 11 countries that underwent capital account liberalization
between 1986 and 1995, and a sample of 8 “control” countries that were subject to no major capital account
reforms in this time period. The liberalizing countries are Brazil, India, Korea, Malaysia, Mexico, Nigeria,
Pakistan, Philippines, Sri Lanka, Thailand and Turkey. Although over two-dozen sovereign nations
implemented financial market liberalization in varying degrees in this time period, our sample is truncated for
unavailability of income share data. For example, only pre-liberalization income share data are available for
Chile and Morocco, while no income share data are available for other liberalizing countries such as
Argentina, Taiwan and Venezuela. The control countries in our sample are Bangladesh, Cote d'Ivoire,
Guatemala, Jamaica, Kenya, Niger, Sierra Leone and Trinidad and Tobago. The fact that these represent the
same regions as the liberalizing countries mitigates possible region-specific effects when comparing
distributions between the liberalizing and control countries.
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Annual income share data are compiled both from Deninger and Squire (1996) and the World
Income Inequality Database (WIID). These data, which are available for T years for county i, yield an
i
unbalanced panel for our data set. All stock market data, deflated by the price index, are taken from World
Bank Database on Financial Structure and Economic Development (FSED). Country specific data are
obtained from the World Bank’s Socioeconomic Time Series Access and Retrieval (STARS) database, and
rule of law data are from the IRIS data set. A description of the variables is provided in the Appendix. For
dates of first capital account liberalization, we lean on the careful dating procedures developed by Bekaert
and Harvey (2000), and Henry (1999, 2000a). The liberalization dates are presented in Table 1a. Summary
statistics of the key variables are in Table 1b. All data are measured at the annual frequency.
B. Mechanisms
There are a few important channels by which stock market liberalization could differentially affect
different income groups in the population. Standard international asset pricing models (e.g., Stulz (1995))
predict that global capital market integration may reduce the domestic cost of equity capital.5 Although the
domestic risk-free rate could rise above its autarky rate in the event of liberalization, research preceding ours
indicates that the equity premium falls in the sample of 12 emerging markets we consider (see, for example,
Tesar and Werner (1998), Stulz (1999b), Bekaert and Harvey (2000), Henry (2000a)). If equity market
liberalization reduces the cost of equity capital, then holding future cash flows fixed, an immediate
implication is an increase in the country’s equity price index and, from a valuation perspective, capital gains
in the liberalizing country at least over the short horizon. However, if participation in the stock market is
segmented by income groups, then these gains will accrue only to those income groups that own equity, and
ceteris paribus the measured response to liberalization will be higher for those groups whose income depends
directly on the equity market. Although we have very sparse data on stock market participation in emerging
markets, there is anecdotal evidence to strongly suggest that equity ownership is largely restricted to the upper
income classes in the countries we sample (e.g., Beim and Calomiris, 1999).
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Over the short horizon, stock market liberalization may also differentially impact the different
income groups if access to credit markets is disparate within the population. By reducing the cost of capital,
stock market liberalizations increase the net present valuation (NPV) of ongoing investments, while also
rendering previous negative NPV projects feasible under a lowered cost of external finance.6 Since there is
evidence that growth is strongly positively associated with lowered cost of financing (see Rajan and Zingales
(1996)), there will be a measured increase in income via entrepreneurial wealth and retained earnings
following the event of stock market liberalization. However, if credit market imperfections limit lower
income groups’ access to credit, as in the models of Galor and Zeira (1993), and Ray (1998), such gains will
be disproportionately allocated to the groups with better access to bank credit and external financing.
Capital account liberalization may also lead to distributional changes by affecting factors
unobservable to the analyst. For example, the implementation of stock market liberalization might signal a
change in domestic fundamentals that leads firms to expect a better environment for growth, as hypothesized
in Bartolini and Drazen (1997). Improved expectations might be particularly strong for firms that are closely
tied to the domestic government because they are in the best position to appropriate the gains from capital
market integration, as implied by the rent-seeking models of Krueger (1974) and Bhagwati (1996). In
particular, favored firms or investors may receive better information, or explicitly influence reforms that reap
private benefits. To the extent that members of the upper income quintiles are tightly linked with the domestic
governments, these factors should most strongly impact their income shares post liberalization. Therefore, an
a priori assumption is that the measured income of the upper quantiles will be inflated via this channel. If
these groups undertake investments because they have private information of their prospects, then one would
observe an increase in their mean income share even after controlling for contemporaneous increases in stock
market valuation and investment. One might speculate, in the spirit of the Kuznets’s (1955) inverted-U

5 For instance, the presence of domestic investment opportunities could lead to net capital inflows that lower
the riskless rate; and, greater risk sharing between domestic and foreign investors could result in reducing the
risk premium (e.g., Errunza and Losq (1985)).
6 Henry (2000b) finds evidence that stock market liberalization leads investment booms.
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