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Is Financial Openness a Bad Thing? An Analysis on the Correlation Between Financial Liberalization and the Output Performance of Crisis-Hit Economies

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  • Ito, Hiro
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Abstract

This paper investigates the link between capital account openness and the output cost associated with a currency crisis. Although the Malaysian experience during the Asian crisis of 1997-98 made many researchers and policy makers interested in the effectiveness of a policy restricting cross-border financial transactions to minimize the output cost, this association has not been exposed to a thorough empirical investigation. The probit analysis in this paper shows that the higher the level of financial openness is, the less likely countries are to experience a currency crisis among industrialized and less developed countries. It is found that a higher level of financial openness prior to a crisis helps to reduce output losses for industrialized countries, but not for less developed or emerging market countries. It is also shown that the duration of post-crisis output contraction can be shorter when an industrialized country has a high level of financial openness, but for the group of EMGs the duration of output contraction can be lengthened if a country has more open capital accounts. However, once the country encounters a currency crisis, the effect of capital account openness differs depending on the level of development. The post-crisis level of financial openness helps industrialized countries to reduce the magnitude of output losses while it increases post-crisis output losses for emerging market and less developed countries. A higher rate of financial liberalization is also found to be detrimental to less developed countries. When the dynamics of output gaps after a crisis are investigated, it is found that the negative effect of a higher level of capital account openness lasts for at least three years for emerging market countries. In general, I have found that institutional development such as corruption, law and order, and bureaucratic quality, rather than the level of openness in financial markets, is important in lowering the size of post-crisis output losses for the groups of less developed or emerging market countries. Only the group of IDCs appears to be able to reap the effect of capital account liberalization in terms of reducing the size of post-crisis output losses. Moreover, Mahathir’s type of capital restriction policy immediately after the breakout of a crisis does not appear to be effective.

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Bibliographic Info

Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number qt5zb2v4c5.

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Date of creation: 01 Aug 2004
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Handle: RePEc:cdl:ucscec:qt5zb2v4c5

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Keywords: Currency crisis; banking crisis; capital controls; financial liberalization;

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References

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  1. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  2. Hali J. Edison & Francis E. Warnock, 2001. "A simple measure of the intensity of capital controls," International Finance Discussion Papers 708, Board of Governors of the Federal Reserve System (U.S.).
  3. Hali J. Edison & Carmen M. Reinhart, 2000. "Capital controls during financial crises: the case of Malaysia and Thailand," International Finance Discussion Papers 662, Board of Governors of the Federal Reserve System (U.S.).
  4. Ethan Kaplan & Dani Rodrik, 2002. "Did the Malaysian Capital Controls Work?," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 393-440 National Bureau of Economic Research, Inc.
  5. Leonardo Bartolini & Allan Drazen, 1996. "Capital Account Liberalization as a Signal," NBER Working Papers 5725, National Bureau of Economic Research, Inc.
  6. Graciela Laura Kaminsky, 1997. "Leading Indicators of Currency Crises," IMF Working Papers 97/79, International Monetary Fund.
  7. Roberto Chang & Andres Velasco, 1999. "Liquidity Crises in Emerging Markets: Theory and Policy," NBER Working Papers 7272, National Bureau of Economic Research, Inc.
  8. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 1998. "What Caused the Asian Currency and Financial Crisis?," Temi di discussione (Economic working papers) 343, Bank of Italy, Economic Research and International Relations Area.
  9. Frankel, Jeffrey A. & Rose, Andrew K., 1996. "Currency crashes in emerging markets: An empirical treatment," Journal of International Economics, Elsevier, vol. 41(3-4), pages 351-366, November.
  10. Honohan, Patrick & Klingebiel, Daniela, 2003. "The fiscal cost implications of an accommodating approach to banking crises," Journal of Banking & Finance, Elsevier, vol. 27(8), pages 1539-1560, August.
  11. Barry Eichengreen & David Leblang, 2003. "Capital account liberalization and growth: was Mr. Mahathir right?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 8(3), pages 205-224.
  12. Heckman, James J, 1979. "Sample Selection Bias as a Specification Error," Econometrica, Econometric Society, vol. 47(1), pages 153-61, January.
  13. Jose De Gregorio & Sebastian Edwards & Rodrigo O. Valdes, 2000. "Controls on Capital Inflows: Do they Work?," NBER Working Papers 7645, National Bureau of Economic Research, Inc.
  14. Joshua Aizenman, 2002. "Financial Opening: Evidence and Policy Options," NBER Working Papers 8900, National Bureau of Economic Research, Inc.
  15. Menzie D. Chinn & Hiro Ito, 2002. "Capital Account Liberalization, Institutions and Financial Development: Cross Country Evidence," NBER Working Papers 8967, National Bureau of Economic Research, Inc.
  16. Sebastian Edwards, 1999. "Crisis Prevention: Lessons from Mexico and East Asia," NBER Working Papers 7233, National Bureau of Economic Research, Inc.
  17. Reuven Glick & Ramon Moreno & Mark Spiegel, 2001. "Financial crises in emerging markets," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue mar.23.
  18. Frankel, Jeffrey A & Rose, Andrew K, 1996. "Currency Crashes in Emerging Markets: Empirical Indicators," CEPR Discussion Papers 1349, C.E.P.R. Discussion Papers.
  19. Michael M Hutchison & Ilan Noy, 2002. "Output Costs of Currency and Balance of Payments Crises in Emerging Markets," Comparative Economic Studies, Palgrave Macmillan, vol. 44(2-3), pages 27-44, September.
  20. Sebastian Edwards, 2001. "Capital Mobility and Economic Performance: Are Emerging Economies Different?," NBER Working Papers 8076, National Bureau of Economic Research, Inc.
  21. Isriya Nitithanprapas & Sunil Rongala & Thomas D. Willett, 2002. "The Role of Capital Controls and Currency Regimes in the Asian Crisis," Claremont Colleges Working Papers 2002-21, Claremont Colleges.
  22. Rudi Dornbusch, 2001. "Malaysia: Was it Different?," NBER Working Papers 8325, National Bureau of Economic Research, Inc.
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Cited by:
  1. Ito, Hiro, 2006. "Financial development and financial liberalization in Asia: Thresholds, institutions and the sequence of liberalization," The North American Journal of Economics and Finance, Elsevier, vol. 17(3), pages 303-327, December.
  2. Hiro Ito & Menzie Chinn, 2007. "Price-Based Measurement Of Financial Globalization: A Cross-Country Study Of Interest Rate Parity," Pacific Economic Review, Wiley Blackwell, vol. 12(4), pages 419-444, October.
  3. Menzie D. Chinn & Hiro Ito, 2005. "What Matters for Financial Development? Capital Controls, Institutions, and Interactions," NBER Working Papers 11370, National Bureau of Economic Research, Inc.
  4. Wei Huang, 2006. "Emerging Markets, Financial Openness and Financial Development," Bristol Economics Discussion Papers 06/588, Department of Economics, University of Bristol, UK.

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