Institutions, inward FDI, trade openness and credit volatility in emerging market economies

Abstract

Determinants of credit volatility are still undecided. The study’s aim is to investigate the impact of institutions, foreign direct investment and trade openness on credit volatility in emerging countries. Four institutional quality indicators such as government effectiveness, regulatory quality, rule of law, and control of corruption are used to estimate the effects of institutions on credit volatility. A panel data covers 36 emerging market economies over the period of 2002-2013. By employing two–way system GMM estimation, this study finds that the effect of inward FDI on credit volatility is negative for both sectors; and the effect of trade openness is significant, but is different between the two sectors. The effect of some institutions on credit volatility is basically the same direction for the two sectors, such as: government effectiveness and rule of law have positive effects, and control of corruption is negative. Adding interaction terms between institutions and inward FDI and trade openness, we find that improvements in institutions (such as government effectiveness, rule of law and regulatory quality) increase significantly positive effects of inward FDI and trade openness on public sector credit volatility that are opposite to the effects on private sector. This implies that reforms in institutions in emerging economies are still biased in favor of public sector to access financial markets. In addition, after the 2008 financial crisis, improvements in institutions in emerging economies are related to a reduction in credit level to private sector. Especially, the study finds that improvements in control of corruption play an important role in increasing the effect of inward and trade openness on credit level to both sectors.