Does Financial Integration Increase Exports

Does Financial Integration Increase Exports?
Evidence from International Industry-Level

Data
Author(s): Nurullah Gur
Source: Emerging Markets Finance & Trade, Vol. 49, Supplement 5: Structural Issues and
Transition in Emerging Markets (November–December 2013), pp. 112-129
Published by: Taylor & Francis, Ltd.
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Does Financial Integration Increase Exports?
Evidence from International Industry-Level Data
Nurullah Gur
ABSTRACT: In this paper, I examine whether financially integrated countries export rela
tively more in industries that depend heavily on external finance. I consider three different
components of financial integration: international portfolio equity investments, foreign
direct investments, and external debt. The results show that, of these three components,
international portfolio equity investments have the strongest and most robust effect on the
sectoral composition of export flows. International portfolio equity investments increase
exports relatively more in industries that depend heavily on external sources of finance. I
also find that this positive effect on exports disappears when the quality of institutions
is low.
KEY WORDS: external debt, exports, FDI, financial constraints, international portfolio
equity investments.
Standard international trade theories assume that financial markets are perfect. However,
financial markets are not frictionless in the real world. The presence of financial friction
implies that financial constraints might affect export performance. Exporting is a costly
activity, and therefore more external finance is needed to cover additional sunk, fixed,
and variable costs of exporting (Manova 2010). In accordance with this argument, theo
retical and empirical papers show that external finance opportunities affect comparative
advantage and export performance (AbuAl-Foul and Soliman 2008; Beck 2002, 2003;
Huretal. 2006; Kietzerand Bardhan 1987; Manova 2008). While a large body of empiri
cal evidence has established the importance of domestic financial development on the
sectoral composition of export, evidence on the effect of financial integration on exports
has been limited. Therefore, I examine whether financially integrated countries export
relatively more in industries that depend heavily on external finance.
Policy considerations and theoretical disputes make it important to analyze the impact
of financial integration. Some economists argue that financial integration is essential
for prosperity and stability (e.g., Mishkin 2006). Other economists claim that financial
integration is associated with greater instability, and therefore it exacerbates economic
fluctuations (e.g., Stiglitz 2002). In fact, financial integration has promised benefits. It has
been argued that financial integration augments domestic savings, improves allocation of
Nurullah Gur (nurullahgur@yahoo.com; ngur@ticaret.edu.tr) is an assistant professor of eco

nomics, Istanbul Commerce University, Istanbul, Turkey. The author thanks the guest editor,
Gökhan Özertan, and an anonymous referee for their comments and suggestions. He also thanks
Ahmet Faruk Aysan, Holger Breinlich, Horst Feldmann, Mehmet Gokhan Gokalp, Avni Önder
Hanedar, Gordon Kemp, Patrick Nolen, George Symeonidis, and participants in the workshop
on "Structural Issues in Emerging Market Economies," Bogaziçi University Center for Innova
tion and Competition Based Development Studies, Istanbul, Turkey, January 25, 2013, for their
helpful comments.
Emerging Markets Finance & Trade / November-December 2013, Vol. 49, Supplement 5, pp. 112-129.
© 2014 M.E. Sharpe, Inc. All rights reserved. Permissions: www.copyright.com
ISSN 1540-496X (print)/ISSN 1558-0938 (online)
DOI : 10.2753/REE 1540-496X4905S507
November-December 2013, Volume 49, Supplement 5 113
capital, reduces the cost of external capital, and generates technological and managerial
expertise. However, the effect of financial integration is quite mixed and controversial (see
Kose et al. 2010; Prasad et al. 2003). Considering this controversial conclusion, Kose et
al. (2010) argue that financial integration would not be beneficial directly but would be
beneficial indirectly through financial market development, institutional development,
and macroeconomic discipline. Financial integration also has some potential costs. Inter
national market imperfections, such as momentum trading, herding and panics, and the
speculative nature of capital flows, can lead to financial volatility, crises, and contagion
(Prasad et al. 2003). Large foreign capital inflows might also cause exchange-rate ap
preciation, which could lead to a decline in exports (Johnson et al. 2007; Rodrik 2008).
Since the results are mixed and controversial in this field, one of the main motivations
of this paper is to provide new evidence.
My framework is similar to Manova's (2008). Like Manova, I focus on the effect
of financial integration on exports but with two main differences from Manova. First,
I use de facto measures of financial integration rather than de jure measures. While de
jure measures of financial integration are associated with capital-account liberalization
policies, de facto measures are associated with actual capital flows.' Most of the recent
papers emphasize that de jure measures suffer from a variety of shortcomings (Kose
et al. 2010; Obstfeld 2008; Prasad et al. 2003). De jure measures do not accurately
capture the degree of financial integration and enforcement of capital controls because
they are based on various restrictions that might not fully stop capital flows. De facto
measures provide a better picture of the extent of a country's integration into global
financial markets.
Second, I consider three different components of financial integration (international

portfolio equity investments, foreign direct investment [FDI], and external debt) rather
than using only one dimension. It is important to note that the components of interna
tional capital flows differ markedly in terms of volatility and effects. External debt and
portfolio equity investments are substantially more volatile than FDI (Prasad et al. 2003).
International portfolio equity investments have the potential to deepen domestic financial
markets and to improve corporate governance among domestic firms (Kose et al. 2009;
Obstfeld 2008). Even though external debt flows provide some external financing op
portunities, external debt flows might not be as effective as equity investments. External
debt flows might lead to inefficient capital allocation under poorly supervised banking
systems and generate moral-hazard problems in the case where debt is guaranteed by
the government or international financial institutions (Kose et al. 2009). FDI can gener
ate technology spillovers and provide better management practices (Borensztein et al.
1998). Therefore, comparing the effects of these three different components of financial
integration is crucial.
For theoretical disputes and policy considerations, it is important to examine whether
financially integrated countries export relatively more in financially dependent industries.
I use a difference-in-difference approach pioneered by Rajan and Zingales (1998). My
results show that the effect of international portfolio equity investments on the sectoral
composition of export flows is the strongest and most robust of the three different compo
nents of financial integration. International portfolio equity investments increase exports
relatively more in industries that are heavily dependent on external sources of finance.
I also find that this positive effect on exports disappears and turns negative when the
quality of institutions is low. The last result shows that well-functioning institutions are
needed to gain from financial integration.
114 Emerging Markets Finance & Trade
Literature Review
This paper is related to the literature on financial markets and export. Theoretical and em
pirical papers show that well-functioning financial markets create comparative advantage,
thus increasing exports. On the theoretical side, Beck (2002) and Kletzer and Bardhan
(1987) propose that financial development is a source of comparative advantage in the
presence of financial frictions. On the empirical side, Beck (2003) shows that economies
with higher levels of financial development tend to specialize in industries that are more
dependent on external finance. Hur et al. (2006) find that countries with well-developed
financial markets have higher export shares and trade balances in industries with more
intangible assets. In parallel with these papers, Manova (2008) finds that equity-market
liberalization increases exports disproportionately more in industries intensively using
external finance and intangible assets. AbuAl-Foul and Soliman (2008) find that FDI has
a positive effect on the host country's merchandise and manufacturing exports in four
countries in the Middle East and North Africa (MENA) region. In a more recent paper,
He (2012) finds that financial liberalization has a positive effect on exports in China.
This paper is also related to recent literature on financial integration. While most of
the papers in this literature use cross-country data (e.g., Bekaert et al. 2005; Edison et
al. 2002; Kose et al. 2009; Quinn 1997; Rodrik 1998), some papers employ a difference
in-difference approach. Vlachos and Waldenstrom (2005) find that financial integration
does not have a positive effect on the growth of financially dependent industries. In a
recent paper, Eichengreen et al. (2011) find that financially dependent industries experi
ence higher growth in countries with liberalized financial markets. However, the positive
effects of financial integration do not hold during financial crises. Maskus et al. (2012)
examine the impact of financial integration on research and development (R&D) inten
sities in Organization for Economic Cooperation and Development (OECD) countries.
Among multiple forms of financial integration, only FDI has a significant effect. They
find that the stock of FDI liabilities and assets increases R&D intensity more in industries
intensively using external financing and intangible assets.
Data
I use industry-level export data from the Trade Production and Protection Database, which
is constructed by Nicita and Olarreaga (2007).2 Like Manova (2008), I use export flows
as the dependent variable. Since most of the country-level data after the mid-1990s is
widely available, I use the most recent data available for industry-level export as well.
For this reason, my dependent variable is the average of total exports for industries of
three-digit International Standard Industrial Classifications (ISIC) level over 1996-2004.
I average total exports to smooth the effects of any year-to-year fluctuations in the level
of total exports across industries. Appendix A lists the countries included in the analysis.
Appendix B lists the industries included in the analysis.
I use three different variables that describe financial integration. Portfolio equity
investment measures ownership of shares of companies and mutual funds below the 10
percent threshold. FDI includes controlling stakes in acquired foreign firms of at least
10 percent of an entity's equity as well as greenfield investments. External debt includes
portfolio debt securities, bank loans and deposits, and other debt instruments. My financial
integration variables are from Lane and Milesi-Ferretti (2007) and include total assets
and liabilities. Even if the stock of assets and liabilities does not have sharp fluctuations
across the short period, I use averages over the period 1996-2004 to smooth the effects of
any potential fluctuations. PORT is the stock of portfolio equity assets and liabilities as a
share of the gross domestic product (GDP). FDI is the foreign direct investment assets and
liabilities as a share of GDP. DEBT is the stock of foreign debt assets and liabilities as a
share of GDP. I use the sum of international assets and liabilities relative to GDP for each
of the indicators of financial integration, which is similar to using the sum of exports and
imports relative to GDP as an indicator of trade openness. Following Edison et al. (2002)
and Maskus et al. (2012), I include both assets and liabilities since theoretical concepts
of financial integration include both the ability of foreigners to invest in a country and
the ability of residents to invest abroad. As a robustness check, I also follow Kose et al.
(2009) and Vlachos and Waldenstrom (2005) and use stock of liabilities.3
Financial development (FD) is measured as the share of private credit by deposit money
banks and other financial institutions to GDP. Market capitalization (MARCAP) is the stock
market capitalization divided by GDP. FD and MARCAP are from the Financial Develop
ment and Structure Database, which is constructed by Beck et al. (2010). The measure
for rule of law (RULE) is from the Worldwide Governance Indicators. My measure of
labor regulation {LR) is an index constructed by Botero et al. (2004). As a measure for the
regulation of entry, I use data from Djankov et al. (2002). Real per capita GDP (GDPpc)
is taken from the Penn World Tables. Measures for factor endowments are from Caselli
(2005). Physical capital per worker is used as a proxy for capital endowments. Physical
capital per capita (C) is calculated according to the perpetual inventory method. Human
capital per worker (H) is constructed from the average years of schooling in a country
with Mincerian nonlinear returns to education.
The proxies for industry characteristics used in this paper are measured for twenty
eight manufacturing industries at the three-digit ISIC level in the United States. External
financial dependence (FINDEP) is defined as the share of investment that is not financed
through internal cash flows. These data are from Ilyina and Samaniego (2011 ). Following
Rajan and Zingales ( 1998), Ilyina and Samaniego use data from Standard and Poor's Com
pustat for U.S. firms in twenty-eight industries to construct a proxy for external financial
dependence. A firm's dependence on external finance is calculated as capital expenditures
minus cash flow from operations divided by capital expenditures. Capital expenditures
correspond to line 128 in Compustat. Cash flow from operations is defined as cash flow
from operations plus changes in payables minus changes in receivables plus changes
in inventories and is computed using Compustat's lines 2, 3, 70, and 110 or lines 302,
303, and 304 if available. The industry-level measure is the median value of dependence
on external finance for U.S. firms belonging to the same industry. The industry value is
calculated as median in order to prevent outliers from dominating the results.
My asset tangibility index (TANG) is measured as the ratio of tangible assets to total
assets for the median firm in each industry in the United States. TANG is also from Ilyina
and Samaniego (2011 ). Industry contract intensity (CONT) is formulated by Nunn (2007)
to measure the importance of relationship-specific investments across industries by using
1997 U.S. input-output tables. My proxy for industry technological volatility (VOL) is
the standard deviation over the absolute value of mean annual growth rate in value added
at three-digit ISIC industries for the United States. This proxy is constructed by Braun
(2003). Entry rate (ENT) is defined as the number of new firms divided by average number
of firms at three-digit ISIC industries for the Unites States as formulated by Dunne et al.
(1988). They were previously used by Micco and Pagés-Serra (2007). Physical capital
intensity (CAPINT) corresponds to the median of the ratio of gross fixed capital formation
to value added in the United States in each industry. The index for human capital intensity
(HUMINT) is the median of the industry's mean wage over that of the whole U.S. manu
facturing sector. The original data set of CAPINT and HUMINT is CompustaL CAPINT
and HUMINT are constructed by Braun (2003). Appendix C describes the variables, and
Appendix D provides summary statistics of the variables.
Empirical Methodology
The empirical methodology is based on a difference-in-difference approach pioneered

by Rajan and Zingales (1998). They follow the theoretical idea that financial markets
help firms overcome problems of moral hazard and adverse selection, thus financial
development should disproportionately help firms that need more external finance.
Rajan and Zingales hypothesize that there are underlying technological reasons why
industries differ in their use of external financing opportunities, and these persist
across countries. In an economy where financial markets are relatively frictionless,
the supply of external financing will be elastic. Therefore, differences in the actual
use of external funds will reflect not the supply of external financing opportunities
but differences in demand for external financial opportunities. Rajan and Zingales
use data from the United States to derive the external financial dependence of a
given industry. There are two main reasons that explain why this approach uses U.S.
industry data as a proxy for industry structure. First, rich and high-quality industry
level data are available for the United States. Second, financial markets in the United
States are relatively frictionless compared to other countries. In this approach, the
level of financial dependence of each industry is not important for identifying the
coefficients; the ranking of financial dependence of each industry is what matters.
Under the assumption that technological differences within the same industry across
countries are likely to be small, U.S. industry-level data is used as a proxy for industry
structure in this literature.
As in Manova (2008), the following equation is estimated by ordinary least squares

(OLS) to examine whether industries that are relatively more in need of external finance
export relatively more in countries with higher financial integration:
\n(EXPORTk) = yt. + a, + ß(F/( * F1NDEP,) + e„, ( 1 )

where \n(EXPORTk) is the log value of country c's exports in industry averaged over
1996-2004; a, and y are industry and country dummies, respectively; Flc denotes the
level of financial integration in country c; FlNDEPi denotes industry i's need for external
financing, which is measured using the U.S data, and the error term is denoted by eit,4 As
discussed above, FIC includes three different terms: PORTc, FDIC, and DEBTC. The inclu
sion of country and industry dummy variables implies that we do not need to specify any
industry- or country-specific variables that might affect industry growth. Only additional
explanatory variables that vary both with industry and country need to be included.5 If ß
is positive and significant, this suggests financial integration increases exports relatively
more in industries relying on external finance.
The main advantage of this approach is that the problem of endogeneity due to omitted
variable bias is unlikely to be a serious problem since the model controls for country
and industry fixed effects. The interaction term between industry-specific characteristics
(financial dependence) and country-specific characteristics (financial integration) is likely
to be exogenous to the dependent variable. While the proxy for dependence on exter
nal finance belongs to industries in the United States, the dependent variable involves
countries other than the United States. It is less likely that export performance outside
the United States might affect external financial dependence in the United States. While
the variables for financial integration are measured at the country level, export flows are
measured at the industry level. In sum, compared with cross-country studies, the prob
lem of endogeneity due to reverse causality is also quite less likely because there are
fewer reasons why the export performance of a specific industry should affect financial
integration of a country.
Results
Benchmark Results
The benchmark results are shown in Table 1. I interact three measures of financial in
tegration (PORT, FDI, and DEBT) with external financial dependence (FINDEP). As
seen in column 1, PORT* FINDEP is positive and statistically significant at 1 percent.
Column 2 shows that the coefficient of the interaction between FDI and external depen
dence (FDI* FINDEP) is positive, but it is not statistically significant. However, column 3
shows that DEBT* FINDEP is positive and statistically significant at 1 percent. Results in
column 4 show that when I take into account all three dimensions of financial integration
simultaneously, only the coefficient of the interaction term between the stock of portfolio
equity investments and external financial dependence is statistically significant. This result
suggests that international portfolio equity investments increase exports relatively more
in industries that require more external finance.
To understand the impact of international portfolio equity investment, I compare
"miscellaneous petroleum and coal products," which is an industry at the seventy-fifth
percentile of financial dependence (0.256), with "pottery, china, and earthenware," which
has low financial dependence (-0.09) and is at the twenty-fifth percentile of dependence.
Then I consider Malaysia, which has high international portfolio equity investments
(0.208) at the seventy-fifth percentile of the sample, and Moldova, which is at the twenty
fifth percentile of PORT with a value of 0.007. The coefficient of PORT* FINDEP
(0.3831 ), as seen in column 1, implies that if Moldova were to attract as much additional
international portfolio investment as Malaysia, Moldova's miscellaneous petroleum
and coal products (a high external finance dependent industry) exports would rise 1.8
points more than its exports on pottery, china, and earthenware (a low external finance
dependent industry).6
Portfolio equity investments deepen domestic financial markets and thereby provide
more direct channels for new financial opportunities. Even if external debt might provide
new funding opportunities, it is more volatile and less efficient to allocate capital to the
best uses, when we compare it with international portfolio investment. While Harrison et
al. (2004) find that FDI reduces domestic firms' financing constraints, its main potential
benefit is generating technology spillovers and providing better management practices
(Borensztein et al. 1998). Considering these arguments and my results, the stock of in
ternational portfolio equity investments seems to matter more in export performance of
financially dependent industries.
As discussed before, industries with an inherent financial dependence tend to export
more in countries with deep financial systems. Therefore, this is controlled for by in
cluding an interaction term on domestic financial development and external financial
dependence (FD * FINDEP). Table 2 shows that the coefficient of FD * FINDEP is always
123
Table 1. Financial integration and exports
Dependent variable: in(EXPORT) (log of exports averaged over 1996-2004)
PORT* FINDEP 0.3831*** 0.4825*

(0.0761) (0.1364)
FDI* FINDEP 0.1281 -0.1261
(0.0892) (0.0797)
DEBT* FINDEP 0.0878*** -0.0076
(0.0261) (0.0446)
Country fixed effects Yes Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes
Number of countries 96 96 96 96
Number of observations 2,680 2,680 2,680 2,680
fl2 0.831 0.830 0.830 0.831
Notes: Regressions are estimated by OLS. Robust (heteroskedasticity-adjusted) standard errors are in
parentheses. *** Statistically significant at I percent; ** statistically significant at 5 percent; * statisti
cally significant at 10 percent.
12
Table 2. Financial integration, financial development, and exports
Dependent variable: In (EXPORT) (log of exports averaged over 1996-2004)
PORT* FINDEP 0.2608***

(0.0942)
FDI* FINDEP -0.0573
(0.0871)
DEBT* FINDEP 0.0352
(0.0319)
FD* FINDEP 0.2467** 0.4326*** 0.3399*
(0.1037) (0.1038) (0.1037)
Country fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Number of countries 92 92 92
Number of observations 2,568 2,568 2,568
ft2 0.829 0.828 0.828
parentheses. *** Statistically significant at 1 percent; ** statistically significant at 5 percent; * statisti
positive and highly significant, suggesting that domestic financial development affects
comparative advantage. Among the three main interaction terms, only the coefficient of
PORT* FINDEP is statistically significant after controlling for the interaction term be
tween domestic financial development and external financial dependence. Therefore, the
results in Table 2 reinforce my first results. As expected, the magnitude of PORT* FINDEP
decreases when I include an interaction term between financial development and external
financial dependence.
12
Table 3. Traditional sources of comparative advantage
Dependent variable: In (EXPORT) (log of exports averaged over 1996-2004)
PORT* FINDEP 0.3586*** 0.3377*** 0.3322***

0.3322*
(0.0815) (0.0798) (0.0715)
C* CAPINT 0.4516 -1.1922
(0.5601) (0.9220)
H* HUMINT 1.1414*** 1.3912***
1.3912*
(0.1969) (0.3203)
R2 0.833 0.839 0.839
parentheses. *** Statistically significant at 1 percent; ** statistically
** statistically
significant
significant
at 5 percent;
at 5 percent;
* statisti
* statist!
Additional Evidence
In this section, I do further analysis to check the strength of the effect of international
portfolio equity investments. First, following Romalis (2004), I include different interac
tion terms between countries' endowments (physical capital and human capital) and the
factor intensity of each factor to control for the importance of countries' factor endowments
as traditional sources of comparative advantage. Thus, I control for traditional sources
of comparative advantage by including different interaction terms between countries'
endowments and the intensity of each factor. Table 3 shows that countries endowed with
physical capital tend to export relatively more in physical-capital-intensive industries,
but it is surprising that this effect is not statistically significant. However, human-capital
intensive industries experience better export performance in countries with a high level
of human capital. Table 3 also shows that the coefficient of PORT* FINDEP is always
positive and statistically significant at 1 percent even after controlling for traditional
sources of comparative advantage.
Previous studies indicate the impact of institutional quality on international trade. In
an influential paper, Nunn (2007) finds that countries with better contract enforcement
export more in industries for which relationship-specific investments are more important.
To control for this effect, I add an interaction term between rule of law and industry con
tract intensity (RULE* CONT). As in Nunn (2007), column 1 of Table 4 shows that the
coefficient of this interaction term is positive and statistically significant. In addition to
contracting institutions, regulations might affect export performance. For example, entry
regulations reduce competition, hinder the creative destruction process, and thus result
in low productivity and comparative disadvantage (see Barseghyan 2008). In line with
this argument, Pang et al. (2010) show that entry regulations discourage exports more
severely in industries with low natural entry barriers (higher entry rate). Therefore, I also
use an interaction term between entry regulations and industry entry rate (ER*ENT). As
seen in column 2, entry regulations reduce exports more in industries with low natural
entry rates.
123
Table 4. New sources of comparative advantage
Dependent variable: \n[EXPORT) (log of exports averaged over 1996-2004)
PORT* FINDEP 0.3232*** 0.3688*** 0.3822*** 0.3323*

(0.0617) (0.0681) (0.0715) (0.0601)
RULE*CONT 0.8865*** 0.7282*
(0.1470) (0.1656)
ER* ENT -0.7247** -0.1338
(0.3200) (0.3435)
LR* VOL -0.0673 -0.0448
(0.1526) (0.1539)
Country fixed effects Yes Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes
Number of countries 96 68 71 68
Number of observations 2,680 1,903 1,987 1,903
R2 0.834 0.853 0.853 0.854
parentheses. *** Statistically significant at 1 percent; ** statistically significant at 5 percent: * statisti
In addition to entry regulations, labor-market regulations might matter but through

a different channel. Differences in labor-market regulations might affect how firms can
adjust to idiosyncratic demand and productivity shocks. Cunat and Melitz (2012) show that
countries with more flexible labor markets export more in industries where adjustments to
these idiosyncratic shocks are important. I also add an interaction term between the index
for labor market regulations and an industry-level volatility measure (LR* VOL). As in
Cunat and Melitz, I find that high-volatility industries export more in countries with flex
ible labor markets. But the coefficient of LR * VOL is not statistically significant. However,
Table 4 indicates that the significance of our main interaction term (PORT* F1NDEP)
persists even after controlling these new sources of comparative advantage.
Table 5 provides some additional sensitivity tests. Manova (2008) also shows that
equity-market liberalization results in a reallocation of exports toward industries with
greater reliance on intangible assets. Under financial frictions, tangible assets are required
as collateral to obtain financial funds. Therefore, industries with more tangible assets
export relatively more in countries with limited financial opportunities. To control for this
argument, I add an interaction term between international portfolio equity investments
and tangibility of industry (PORT* TANG). Column 1 shows that international portfolio
equity investments increase exports more in industries with more intangible assets. After
adding PORT* TANG, the main interaction term (PORT* F1NDEP) is still positive and
statistically significant at 1 percent.
In my benchmark results, I use the share of private credit by deposit money banks
and other financial institutions to GDP as a proxy for financial development. It might
be argued that the stock of international portfolio equity investments simply captures
other dimensions of financial development. Therefore, I also control for stock market
capitalization over GDP, which is another important aspect of financial development.
Column 2 of Table 5 shows that the coefficient of STOCK* FINDEP is small and not
statistically significant, and the coefficient of PORT* FINDEP remains positive and sta
12 3
Table 5. Other sensitivity tests
Dependent variable: In(EXPORT) (log of exports averaged over 1996-2004)
PORT* FINDEP 0.3478*** 0.3045*** 0.2818***

(0.0763) (0.0751) (0.0695)
PORT* TANG -0.7684*
STOCK* FINDEP 0.0865
(0.3988)
GDP* FINDEP 0.0919*** (0.0945)
(0.0358)
Notes: Regressions are estimated by OLS. Robust (heteroskedasticity-adjusted) standard errors
are in parentheses. *** Statistically significant at 1 percent; ** statistically significant at 5 percent;
* statistically significant at 10 percent.
tistically significant. One might also argue that the effect of international portfolio equity
investments is significant simply because it captures the effect of economic development.
Column 3 shows that portfolio equity investments still improve export performance of
financially dependent industries even after an interaction term between external financial
dependence and log income per capita is accounted for. In sum, my results show that the
effect of international portfolio equity investments is robust.7
Country Heterogeneity
In this section, I allow not only for heterogeneity across industries but also for hetero
geneity across countries. Bekaert et al. (2005) and Kose et al. (2009) find that financial
integration is more beneficial in countries that are financially developed or have a higher
quality of institutions. Prasad et al. (2007) show that only countries with developed
financial markets can benefit from financial integration. Eichengreen et al. (2011) find
that the positive effects of financial integration are limited to countries with developed
financial markets and inclusive economic institutions.
Financial development might be important because international capital flows can

not be channeled to the best uses under a poor-functioning financial system. Financial
integration has also caused costly crises, mostly in countries with underdeveloped
financial systems. Given that well-developed financial systems are usually marked by
better risk-management techniques, prudential financial regulation, better supervision,
and higher competition, financial development can prevent the potential risks caused
by financial integration and therefore provide a more well-founded environment for
international capital flows. The quality of the legal institutions, level of corruption, and
degree of transparency can also affect the allocation of resources. Given that more funds
are circulated under a higher degree of financial integration, the quality of institutions
might matter more in this environment.
12
Table 6. Country heterogeneity
Dependent variable: \n(EXPORT) (log of exports averaged over 1996-2004)
PORT* FtNDEP 0.3688*** 0.3795***

(0.0764) (0.0764)
PORT* FINDEP* FUD -1.2980
PORT* FINDEP* IUD -0.9024**
(1.0930)
(0.4232)
Country fixed effects Yes Yes
Industry fixed
Number effects Yes
of countries 92Yes
96
R2 0.829 0.831
Number of observations 2,568 2,680
parentheses. *** Statistically significant at I percent; ** statistically significant at 5 percent; * statisti
To determine whether there are threshold effects (the positive effects of international
portfolio equity investments may kick in only once institutional quality and domestic
financial development are above a certain level), I follow the strategy used by Eichen
green et al. (2011) and Prasad et al. (2007). I include a separate triple interaction among
international portfolio equity investments, an industry's dependence on finance, and a
dummy variable (FUD) that takes value one if the country is below the median level
of financial development. To test the second threshold effect, 1 include a separate triple
interaction among international portfolio equity investments, an industry's dependence
on finance, and a dummy variable (IUD) that takes value one if the country is below the
median level of institutional quality.
As seen in column 1 of Table 6, international portfolio equity investments have a
positive and statistically significant impact in the financially developed countries; the
coefficient for the financially undeveloped countries is negative but not statistically sig
nificant. Column 2 shows that the effect of international portfolio equity investments is
positive for countries with a high institutional quality. However, the effect of international
portfolio equity investments is reversed for countries with a low institutional quality. This
suggests that countries with poor economic institutions cannot benefit from international
portfolio equity investments.
Conclusion
Countries should provide new external funding opportunities to their firms and industries
in order to export more and have a greater voice in the global economy. Financial integra
tion has been seen as an important way of providing external funding opportunities since
the 1980s. Although it has promised benefits, recent empirical works draw a mixed and
controversial picture of the effects of financial integration. After considering external
financial needs of exporters and promised benefits of financial integration, I analyze the
effect of financial integration on sectoral composition of export flows.
Given that the components of international capital flows differ markedly in terms of
volatility and their effects, I consider three different components of financial integration.
These three components are international portfolio equity investments, foreign direct
investments, and external debt. I also consider that even if financial integration can bring
benefits, these benefits might not be the same across industries. Given that some of the
most important promised benefits of financial integration are to reduce the cost of external
capital and to improve allocation of capital, financial integration might increase exports
relatively more in industries that need more external finance.
The results show that, of the three different components of financial integration, the
effect of international portfolio equity investments is the strongest and most robust. In
ternational portfolio equity investments increase exports relatively more in industries that
are heavily dependent on external sources of finance. I also find that this positive effect
on export disappears and turns negative when the quality of institutions is low.
Consequently, the results provide two important policy implications. First, remov
ing restrictions on international portfolio equity investments can ease domestic credit
constraints and thus increase external financial opportunities for exporters. Second, the
policy implication of this paper can also be interpreted as a sign that the countries that
want to benefit from financial integration must have a strategy in place to improve the
quality of institutions before (or at least contemporaneously with) undertaking financial
integration reforms.
The results do not take into account the possible effects of a global financial crisis
on the relationship between financial integration and export flows because of the data
limitation. Financial integration might have adverse effects on external finance conditions
during financial crises. Providing evidence on channels through which financial integra
tion might affect exports during a global financial crisis will be a crucial task for future
research. Rajan and Zingales's (1998) approach uses the U.S. industry characteristic
as a benchmark to approximate the global industry characteristic. This is not a perfect
proxy. Some papers instrument the U.S.-based proxy for industry growth opportunities
with a second proxy that does not reflect U.S. trends or trends specific to countries (see
Ciccone and Papaioannou 2010; Gur 2012). There are rich data sets that can be used to
find a better global proxy for industry growth opportunities. Unfortunately, the lack of
rich international data on FINDEP has led this literature to rely on using U.S. data as a
proxy. Finding better global proxies for FINDEP will be another important task for future
research to deal with potential benchmarking bias.
Notes
1. Some of the most commonly used de jure measures are (1) a dummy variable, which is cre
ated by the information from International Monetary Fund's (IMF's) Annual Report on Exchange
Arrangements and Exchange Restrictions (AREAER), to measure capital account openness;
(2) Quinn's (1997) capital account openness measure, which is also created by using the infor
mation from IMF's AREAER; (3) the Chinn-Ito index (KAOPEN), which is based on the binary
dummy variables that codify the tabulation of restrictions on cross-border financial transactions
reported in the IMF's AREAER; (4) a dummy variable measure of equity market liberalization,
which is created by using the official year of equity market liberalization. One of the most widely
used de facto measures is based on the data on total external assets and liabilities constructed by
Lane and Milesi-Ferretti (2007).
2. The database is available under the 'Trade Data & Tools" section of the World Bank trade
Web site (http://go.worldbank.org/7CXCSJSGY0/).
3. These results are available from the author upon request.
4. Following the previous papers that use the Rajan-Zingales methodology, I use robust
(heteroskedasticity-adjusted) standard errors. The findings are robust to use clustered standard
errors.
5. The United States (the benchmark country) is excluded from the regressions.
6. This is a hypothetical example based on our econometric results.
7. As discussed above, compared with standard cross-country regressions, any endogeneity
problem that might occur due to omitted-variable bias and/or reverse causality is less likely to occur
in the Rajan-Zingales approach. Nevertheless, I use instrumental variables for financial integration
to mitigate the potential reverse causality problem or measurement error. Edison et al. (2002) use
each country's legal origin as an instrument for financial integration. La Porta et al. (1997) suggest
that legal traditions affect both the laws governing financial transactions and the enforcement of
these laws. Most countries have adopted one of these legal systems through colonialism, conquest,
or outright borrowing. These laws differ in terms of protection of property rights, shareholders, and
creditors. Therefore, they will affect the financial systems of the countries. Legal-origin variables
have been increasingly used as exogenous determinants of financial integration. To conserve space,
the results are not reported, but they are available from the author upon request.
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Appendix A: Country List
Argentina, Armenia, Australia, Austria, Azerbaijan, Bangladesh, Benin, Bolivia, Brazil,

Bulgaria, Cameroon, Canada, Chile, China, Colombia, Costa Rica, Côte d'Ivoire, Cyprus,
Czech Republic, Denmark, Ecuador, Egypt, El Salvador, Ethiopia, Finland, France, Ga
bon, Germany, Ghana, Greece, Guatemala, Honduras, Hong Kong, Hungary, Iceland,
India, Indonesia, Iran, Ireland, Israel, Italy, Japan, Jordan Kenya, Korea South, Kuwait,
Kyrgyzstan, Latvia, Lithuania, Macao, Malawi, Malaysia, Malta, Mauritius, Mexico,
Moldova, Mongolia, Morocco, Mozambique, Nepal, Netherlands, New Zealand, Nigeria,
Norway, Oman, Pakistan, Panama, Peru, Philippines, Poland, Portugal, Qatar, Romania,
Russia, Senegal, Singapore, Slovakia, Slovenia, South Africa, Spain, Sri Lanka, Sweden,
Switzerland, Taiwan, Tanzania, Thailand, Trinidad & Tobago, Tunisia, Turkey, Uganda,
Ukraine, United Kingdom, Uruguay, Venezuela, Yemen.
Appendix B: Industry List

ISIC Industry
311 Food products

313 Beverages
314 Tobacco
321 Textiles
322 Wearing apparel, except footwear
323 Leather products
324 Footwear, except rubber or plastics
331 Wood products, except furniture
332 Furniture, except metal
341 Paper and paper products
342 Printing and publishing
351 Industrial chemicals
352 Other chemicals
353 Petroleum refineries
354 Rubber products
356 Plastics products
361 Pottery, china, and earthenware
362 Glass and glass products
369 Other nonmetallic mineral products
371 Iron and steel
372 Nonferrous metals
381 Fabricated metal products
382 Machinery, except electrical
383 Machinery, electrical
384 Transport equipment
385 Professional and scientific equipment
390 Other manufacturing products
Appendix C: Definitions and Sources of the Variables

Variable Definition Source
PORT International portfolio equity Lane and Milesi-Ferretti (2007)

investment (Assets + Liabilities
over GDP)
FDI Foreign direct investment (Assets + Lane and Milesi-Ferretti (2007)
Liabilities over GDP)
DEBT Foreign debt (Assets + Liabilities over Lane and Milesi-Ferretti (2007)
GDP)
FD Financial development Beck etal.
et al.(2010)
(2010)
RULE Rule of law World Bank Governance Indicators
LR Labor regulations Botero et al. (2004)
ER Entry regulations Djankov et al. (2002)
MARCAP Stock market capitalization over GDP Beck et al. (2010)
GDP Per capita GDP Penn World Tables
C Physical capital per capita Caselli (2005)
H Human capital per worker Caselli (2005)
FINDEP Industry's external financial Data originally come from
dependence Compustat. Ilyina and Samaniego
(2011)
TANG Industry's tangibility of assets Data originally come from
Compustat. Ilyina and Samaniego
(2011)
ENT Industry's entry rate Original source is Dunne et al.
(1988). It is from Micco and
Pagés-Serra (2007)
Pages-Serra
CONT Industry's contract intensity Nunn (2007)
VOL Industry's technological volatility Braun (2003)
CAPINT Industry's physical capital intensity Braun (2003)
HUMINT Industry's human capital intensity Braun (2003)
Appendix D: Descriptive Statistics

Standard
Observations Mean Deviation
In (EXPORT) 2,680 10.8679 3.3176

PORT 96 0.2001 0.4687
FDI 96 0.4181 0.5108
DEBT 96 1.2796 1.3721
FD 92 0.5278 0.4351
STOCK 86 0.4453 0.5215
RULE 96 0.2676 0.9372
ER 68 2.8822 1.2394
LR 71 0.4877 0.1389
GDP 96 8.8156 1.2049
K 72 10.0776 1.5197
H 70 2.1884 0.5794
FINDEP 28 0.1598 0.7351
CONT 28 0.4871 0.2058
ENT 28 0.3803 0.0869
VOL 28 1.5979 1.0629
TANG 28 0.2920 0.1344
KINT 28 0.0694 0.0375
HINT 28 0.9995 0.2771
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Does Financial Integration Increase Exports

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Does Financial Integration Increase Exports?

Evidence from International Industry-Level

Nurullah Gur (nurullahgur@yahoo.com; ngur@ticaret.edu.tr) is an assistant professor of eco

Second, I consider three different components of financial integration (international

The empirical methodology is based on a difference-in-difference approach pioneered

As in Manova (2008), the following equation is estimated by ordinary least squares

\n(EXPORTk) = yt. + a, + ß(F/( * F1NDEP,) + e„, ( 1 )

Dependent variable: in(EXPORT) (log of exports averaged over 1996-2004)

PORT* FINDEP 0.3831*** 0.4825*

Industry fixed effects Yes Yes Yes Yes

Dependent variable: In (EXPORT) (log of exports averaged over 1996-2004)

PORT* FINDEP 0.2608***

Industry fixed effects Yes Yes Yes

Dependent variable: In (EXPORT) (log of exports averaged over 1996-2004)

PORT* FINDEP 0.3586*** 0.3377*** 0.3322***

Industry fixed effects Yes Yes Yes

Dependent variable: \n[EXPORT) (log of exports averaged over 1996-2004)

PORT* FINDEP 0.3232*** 0.3688*** 0.3822*** 0.3323*

Industry fixed effects Yes Yes Yes Yes

In addition to entry regulations, labor-market regulations might matter but through

Dependent variable: In(EXPORT) (log of exports averaged over 1996-2004)

PORT* FINDEP 0.3478*** 0.3045*** 0.2818***

GDP* FINDEP 0.0919*** (0.0945)

Financial development might be important because international capital flows can

Dependent variable: \n(EXPORT) (log of exports averaged over 1996-2004)

PORT* FtNDEP 0.3688*** 0.3795***

Appendix A: Country List

Argentina, Armenia, Australia, Austria, Azerbaijan, Bangladesh, Benin, Bolivia, Brazil,

Appendix B: Industry List

311 Food products

Appendix C: Definitions and Sources of the Variables

PORT International portfolio equity Lane and Milesi-Ferretti (2007)

Appendix D: Descriptive Statistics

In (EXPORT) 2,680 10.8679 3.3176

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PORT* FINDEP 0.3586* 0.3377* 0.3322***

PORT* FINDEP 0.3232* 0.3688* 0.3822*** 0.3323*

PORT* FINDEP 0.3478* 0.3045* 0.2818***

PORT* FtNDEP 0.3688* 0.3795*