Barcelona Economics Working Paper Series Rethinking the Effects of Financial Liberalization Rethinking the E¤ects of Financial Liberalization

During the last few decades, many emerging markets have lifted restrictions on cross-border …nancial transactions. The conventional view was that this would allow these countries to: (i) receive capital in ‡ows from advanced countries that would …nance higher investment and growth; (ii) insure against aggregate shocks and reduce consumption volatility; and (iii) accelerate the development of domestic …nancial markets and achieve a more e¢ cient domestic allocation of capital and better sharing of individual risks. However, the evidence suggests that this conventional view was wrong. In this paper, we present a simple model that can account for the observed e¤ects of …nancial liberalization. The model emphasizes the role of imperfect enforcement of domestic debts and the interactions between domestic and international …nancial transactions. In the model, …nancial liberalization might lead to di¤erent outcomes: (i) domestic capital ‡ight and ambiguous e¤ects on net capital ‡ows, investment, and growth; (ii) large capital in ‡ows and higher investment and growth; or (iii) volatile capital ‡ows and unstable domestic …nancial markets. The model shows how these outcomes depend on the level of development, the depth of domestic …nancial markets, and the quality of institutions. During the last few decades, many emerging markets have lifted restrictions on cross-border …nancial transactions. The conventional view, part of the so-called Washington Consensus, was quite optimistic regarding the e¤ects of …nancial liberalization. An authoritative rendition of such view can be found in a famous speech by Stanley Fischer, Deputy Director of the International Monetary Fund and world leading macroeconomist, who argued that: " Free capital movements facilitate a more e¢ cient global allocation of savings, and help channel resources into their most productive uses, thus increasing economic growth and welfare. [...] International capital ‡ows have expanded the opportunities for portfolio diversi…cation, and thereby provided investors with a potential to achieve higher risk-adjusted rates of returns. And just as current account liberalization promotes growth by increasing access to sophisticated technology, and export competition has improved domestic technology, so capital account liberalization can increase the e¢ ciency of the domestic …nancial system. [...] These are not abstract concepts, but bene…ts that every country represented in this room has enjoyed as a result of its access to the international capital markets. " Stanley Fischer, " Capital Account Liberalization and the Role of the IMF, " speech Mounting empirical evidence (reviewed later) suggests that this conventional view was wrong however. 1 Some of …