Financial Market Integration and Macroeconomic Volatility in the MENA Region: An Empirical Investigation1

1. An earlier version of this paper was presented at the ERF 11th Annual Conference, 14–16 December 2004, Beirut, Lebanon.

Abstract

Using panel data regression models this study examines empirically the impact of regional and international financial integration on macroeconomic volatility in the developing economies of the MENA region over the period 1980–2002. Our empirical results indicate that financial openness is associated with an increase in consumption volatility, contrary to the notions of improved international risk-sharing opportunities through financial integration. Our empirical findings emphasize the role of sound fiscal and monetary policies in driving macroeconomic volatility. In regard to structural reforms, the development of the domestic financial sector is critical, as a high degree of financial sector development is significantly associated with lower macroeconomic volatility. We argue that enhancing regional financial integration might constitute a venue to circumvent the vulnerability of the small open MENA economies to external shocks, and a mean to enhance consumption smoothing opportunities, as well as international financial integration.

Keywords:

• MENA region
• macroeconomic volatility
• financial integration

Keywords:

• JEL CLASSIFICATIONS:
• G10
• E20

Notes

Notes

1. An earlier version of this paper was presented at the ERF 11th Annual Conference, 14–16 December 2004, Beirut, Lebanon.

2. However, Arellano and Medonza (2002) find that the possibility of sudden stops caused by borrowing constraints does not induce any sizable changes in the volatility of output and consumption.

3. For a detailed discussion of the introduction of the euro currency and its impact on the MENA region, see Neaime and Paschakis (2002), Colton and Neaime (2003), and Neaime (2001, 2002).

4. Analysts agree that the appreciation of the real exchange rate was the main cause behind the EMS currency realignments and the devaluation of the markka and the peso. See, for example, Dornbusch (1989), Bruno (1995) and Edwards (1996), among others. It has frequently been suggested (Dornbusch 1989) that countries with higher than average inflation rates could have escaped the problems posed by pegged nominal exchange rates if they had pursued a fixed real exchange rate policy. Had these countries adjusted the nominal exchange rate according to the difference between foreign and domestic inflation so as to maintain a constant but competitive real exchange rate, they would have avoided real exchange rate overvaluations and high interest rates, and they would only have experienced moderate inflation. This suggestion is directed more towards inflation-prone EMS countries such as Italy, Greece, Portugal and Spain, and also MENA countries with high inflation rates and currency pegs, such as recently in Turkey and Egypt, and Jordan in the early 1990s.

5. However, the very recent appreciation of the euro against the dollar since January of 2003 will help reduce MENA's real exchange rates appreciation.

6. This move was perceived by policy makers in the MENA region as a step in the right direction in light of continuing financial and monetary globalization and the latest emerging market crisis since the mid 1990s. Since then the trend has been for emerging economies to move away from intermediate exchange rate regimes, as was the case in Egypt before adopting full flexibility, toward floating regimes and in very few instances toward full fixity. The impressive evolution of Egypt's exchange rate regime reflects its changing role in the conduct of an independent national monetary policy and the degree to which the country is integrating into the world financial system. Thus, given the greater access for Egyptian investors to international capital markets, Egypt has certainly gained greater monetary policy autonomy.

7. For a detailed discussion of exchange rate policies, see Mansoorian and Neaime (2002, 2003), and Neaime (2000).

8. On 25 May 1981, the leaders of the United Arab Emirates, Bahrain, Saudi Arabia, Oman, Qatar and Kuwait met in Abu Dhabi to discuss the establishment of the Gulf Cooperation Council aiming at reaching coordination, integration and inter-connection among the member states in all fields and to achieve unity at a later stage. The six member countries have a lot in common in terms of cultural, historical, social and religious values. These factors along with the geographic entity facilitated interaction and discussion and created homogenous values and characteristics. The objective of the GCC is to strengthen coordination, integration and ties between their people. GCC also aims at conforming some fields such as economy, finance, trade, tourism, legislation, administration, agriculture and others among the member countries.

9. This is a dummy variable, which takes on the value of 1 in the presence of trade restrictions and 0 otherwise.

10. The measure of trade openness used is defined as the ratio of total exports plus imports divided by GDP.

11. This is a dummy variable, which takes on the value of 1 in the presence of capital account restrictions and 0 otherwise.

12. Capital flows are defined as foreign direct investment plus portfolio flows.

13. Terms of trade for a given MENA country i are measured as the ratio of country i's producers’ price index (PPI) to proxy the price of exports, and the consumer price index (CPI) to proxy the price of imports.

14. Fiscal balance is defined as the difference between government spending (inclusive of debt service) and government revenues.

15. Oil prices are obtained from the OPEC Statistical Bulletin, 2003 and from the Survey of Economic and Social Developments in the ESCWA Region, various issues.

16. Bekaert et al. (2002) report that capital account openness increases the volatility of output and consumption in emerging market countries.

17. Gavin and Hausmann (1996) report a significant positive association between financial integration proxied by capital flows and GDP volatility.

18. An important fiscal development in oil-producing MENA countries is that some of these countries have moved during the early 1990s into the category of debtors’ countries due to the increase in their external debts and deficits. For example, in Saudi Arabia the budget deficit in the last five years has averaged 4.5% of GDP and the government total debt is now at about 95% of GDP. With a budget deficit that is due mainly to public salaries and debt service payments, the Saudi government will feel the pressure of any decrease in oil prices.