Market Institutions, Government Agency, and Capital Flows

During the last few decades, developing countries have embarked in a process of financial liberalization. Despite high initial hopes, the results of this process have by most accounts been mixed: while in some countries liberalization spurred domestic investment and growth, in other countries a modest (if any) effect on investment was accompanied by widespread financial fragility. To explain these diverging patterns, existing empirical work stresses the quality of a country’s financial institutions such as investor rights and corporate governance regimes; only in countries with developed financial systems, the argument goes, can financial liberalization enable domestic banks and entrepreneurs to attract foreign funds and employ them efficiently. This argument has prompted international institutions and academic economists to advocate domestic financial reform as a crucial prerequisite for effective financial liberalization. Despite its intuitive appeal, this view overlooks the fact that foreign investors in emerging economies are not only wary of the risks directly associated to the quality of the domestic legal and financial infrastructures, but also of those generated by the local government. Over and above direct expropriation by capital users, investors in emerging economies are subject to the risk that the government may hinder their returns through such policies as opportunistic devaluations, high inflation, excess taxation, and sovereign default. This possibility raises one key question: Does the presence of this type of government agency obliterate the role of financial reforms, or does it still leave significant room for them? The importance of this question is evident in the case of public defaults, which represent a major form of government agency in the real world. Recent defaults in Russia, Ecuador, Pakistan, Ukraine and Argentina, have been followed by private financial turmoil, resulting in severe contractions in credit and output. In these episodes, default often spread to the private sector via banks’ holdings of government bonds. The Russian default in 1998, for instance, triggered large balance sheet losses on Russian banks, which had heavily invested in their government’s bonds. The ensuing financial sector meltdown meant that foreign investors were doubly hurt: besides the direct loss suffered through their public bond-holdings, they also suffered an indirect loss through the default of banks that were exposed to public bonds. At first glance, these events seem to suggest that the effectiveness of financial reform is weakened by the presence of a discretionary government that is not directly constrained by market institutions. In reality, however, the government might be indirectly constrained by these institutions because the latter are likely to affect the extent to which government misbehaviour hurts the domestic economy. A government wary of destroying domestic markets, production and employment, will be indirectly constrained by developed financial institutions when the latter amplify the disruptive impact of government misbehaviour. In the specific case of public default mentioned above, we have already gathered empirical evidence that is strongly consistent with this mechanism: public defaults are associated with turmoil in domestic financial markets, this turmoil is more severe in countries with better financial institutions, and these same countries display a lower likelihood of public defaults. This evidence suggests that better financial institutions may indeed indirectly discipline the government by fostering the impact of default on private markets. The goal of our project is to theoretically study the link between the quality of financial markets and government behaviour, particularly the extent to which a government’s ability to commit on pursuing desirable policies rests upon the quality of its markets. We wish to adopt a general perspective encompassing various government policies such as devaluations, high inflation or excess public spending/taxation. The ultimate goal is to understand whether it is generically true that strong and “complex” markets help discipline governments by making discretionary government intervention costly. If this is the case, the gains of institutional reform aimed at strengthening market development might be greater than was previously thought, and include the major benefit of mitigating government agency.