Are Trade Openness and Financial Development Complementary?

Abstract:Trade liberalization and financial deepening have assumed greater significance for a country’s economic growth performance in recent times. Several theoretical and empirical studies have devoted considerable attention to the association between economic performance and trade liberalization as well as to the connections between financial market development and economic growth. However, literature is sparse in terms of the direct linkages between trade openness and financial sector development. This paper finds that trade openness and financial development are complementary and econometrically tests this hypothesis for India over a period of time. However, two important policy implications of the analysis presented in this paper deserve attention. First, although financial deepening has emerged as an important aspect of the economic growth strategy in the Indian context, since the sources of such a deepening may be both domestic as well as external; the importance of a judicious policy mix cannot be neglected, especially in the wake of the current global financial meltdown. Second, as documented in the econometric analysis, the complementarities between trade openness and financial deepening appear to be less pronounced. However, this should be interpreted with some caution. While the Indian data suggest that trade and financial liberalization policies may possibly be pursued independent of each other, this by no means suggests that there are no reinforcing linkages between the two.