Rethinking the Effects of Financial Liberalization

Economic and institutional reforms coupled with low financial markets sophistication have made developing economies more resilient to crises. Depending on the level of development, a country might be better off postponing financial liberalisation. The conventional view on financial liberalisation posits that countries receiving capital inflows from advanced economies would have better insurance against aggregate shocks and reduced consumption volatility. After the resolution of the debt crisis of the 1980s, many emerging markets turned to financial liberalisation, thinking that it would provide a fast track to development. However, decades later, the evidence on the effects of this policy is at best mixed. Capital often seems to flow in the wrong direction, the impact on investment and growth is not clear and financial liberalisation seems to have increased both output and consumption volatility. IGC researchers Broner and Ventura (2011) revisit the topic of financial liberalisation under a new viewpoint, backed by real-world evidence: the effects of financial liberalisation depend on the level of economic development of the country, on whether it has developed or underdeveloped financial markets, and on whether it has high or low-quality institutions. The authors argue that the conventional view fails to anticipate the full effects of financial liberalisation on debt enforcement – it ignores interactions between foreign and domestic debt by assuming that domestic debt would be enforced even if the foreign one would not. The main problem with non-discriminatory debt enforcement is that defaults will affect both foreign debt and the domestic one, since defaults will induce domestic savers to send parts or all of their savings abroad. As a result, financial liberalisation might decrease domestic sources of financing, leading to higher gross capital flows but with an ambiguous effect on net capital flows and overall development financing. To amend for this shortcoming, Broner and Ventura (2011) develop an analytical framework that internalizes difficulties in discriminating between foreign and domestic debt. Their model helps to explain in a stylized fashion the underlying determinants of financial liberalisation effects: At an intermediate level of development, financial liberalisation leads to capital exports and slows down growth. If it occurs at high levels of development, however, financial liberalisation leads to capital imports and higher growth if beliefs are optimistic, and vice versa, if beliefs are pessimistic. The higher the quality of debt enforcement institutions, the lower the likelihood of domestic savers sanding their savings abroad. As the savings rate increases, average capital stock increases and its volatility decreases. In a different paper IGC researchers Gourinchas and Obstfeld (2011) seek to understand the impact on emerging market economies (EMEs) of the 2007-09 global financial crisis, contrasting the recent crisis with past EME financial crises, as well as with crises that have hit the advanced economies (AEs) during the 20th century. They ask if there are substantive differences between the preludes and aftermaths of various types of crises in EMEs versus AEs, and if the most recent crisis, in which some emerging regions displayed considerable resilience, differs from past ones. Gourinchas and Obstfeld (2011) use panel regressions to isolate the behaviour of key macroeconomic variables before, during, and after three distinct (but sometimes related) types of crisis – sovereign default crises, banking crises, and currency crises. The policy goal is to understand the macro developments that typically precede crises, as well as to understand the economic factors that might aggravate or mitigate crisis severity. Some of the researchers’ most important results, in coherence with Broner and Ventura’s (2011) findings suggest that both AEs and EMEs experience abnormally high economic activity before a banking crisis, but the decline in output once the crisis has hit the economy is larger for advanced countries. In addition, recovery is slower for advanced economies, suggesting a positive relationship between the degree of development and sophistication of the financial sector and the severity of a banking crisis.