Financial Stability of a Small Open Economy under Credit Constraints

Some of the most visible causes for booms and busts in a small, open, financially developing economy include a fragile financial market, exchange rate shocks, and asset price volatility that often result in credit constraints. Because these shocks tend to exaggerate the credit cycles of collateral-based bank lending to the non-tradable sector, an emerging economy experiences a series of financial booms and busts. Further, the fundamental cause of credit frictions is related with market fragility and polarization of industrial bases (NT sector) that are increasingly exposed to various shocks. Shocks interact with fragility to necessitate greater stabilization efforts that often are accompanied by lingering side-effects. Credit flows cannot be dispersed widely since risk cannot be accommodated by investors without implicit government guarantees. The interaction of implicit bailout guarantees and lack of contract enforceability makes market intervention by the authorities a permanent feature of sizable balance sheet effects. Thus, financial market stability in an emerging market context requires extra efforts beyond the usual macro policy framework. For the purpose of securing stability, any serious effort to strengthen the market infrastructures by granting greater access to wider markets must entail rationalization of governance to boost absorptive capacity, which will ease credit constraints.