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The Positive Link Between Financial Liberalization, Growth and Crises

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Aaron Tornell
Frank Westermann
Lorenza Martinez

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Abstract

There is no agreement regarding the growth-enhancing effects of financial liberalization, mainly because it is associated with risky international bank flows, lending booms, and crises. In this paper we make the case for liberalization despite the occurrence of crises. We show that in developing countries trade liberalization has typically been followed by financial liberalization, which has indeed led to financial fragility and a greater incidence of crises. However, financial liberalization also has led to higher GDP growth. In fact, the fastest-growing countries are typically those that have experienced boom-bust cycles. That is, there is a positive link between GDP growth and the bumpiness of credit, which is captured by the negative skewness --not by the variance-- of credit growth. To substantiate our interpretation of the data we present a model that shows why in countries with severe credit market imperfections, liberalization leads to higher growth and, as a by-product, to financial fragility. Thus, occasional crises need not forestall growth and may even be a necessary component of a developing country's growth experience. Finally, our analysis indicates that foreign direct investment does not obviate the need for risky international bank flows, as the latter are the only source of financing for most firms in the nontradables sector.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10293.

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Date of creation: Feb 2004
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Handle: RePEc:nbr:nberwo:10293

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E20 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - General (includes Measurement and Data)
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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  1. Bonfiglioli, Alessandra & Mendicino, Caterina, 2004. "Financial Liberalization, Banking Crises and Growth: Assessing the Links," Working Paper Series in Economics and Finance 567, Stockholm School of Economics. [Downloadable!]
  2. Frederic Mishkin, 2005. "Is Financial Globalization Beneficial?," NBER Working Papers 11891, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  3. Henk C. Kranendonk & Jan Bonenkamp & Johan P. Verbruggen, 2004. "A Leading Indicator for the Dutch Economy – Methodological and Empirical Revision of the CPB System," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  4. Kharroubi, E., 2006. "Illiquidity, Financial Development and the Growth-Volatility Relationship Illiquidity, Financial Development and the Growth-Volatility Relationship," Documents de Travail 139, Banque de France. [Downloadable!]
  5. Demirguc-Kunt, Asli & Kane, Edward J. & Laeven, Luc, 2006. "Determinants of deposit-insurance adoption and design," Policy Research Working Paper Series 3849, The World Bank. [Downloadable!]
    Other versions:
  6. Assaf Razin & Yona Rubinstein, 2005. "Evaluation of Exchange-Rate, Capital-Market, and Dollarization Regimes in the Presence of Sudden Stops," Working Papers 042005, Hong Kong Institute for Monetary Research. [Downloadable!]
    Other versions:
  7. Edgar Demetrio Tovar García, 2007. "Globalización del capital y desarrollo institucional del sistema financiero," Revista de Economía Institucional, Universidad Externado de Colombia - Facultad de Economía, vol. 9(17), pages 75-107, July-Dece. [Downloadable!]
  8. M. Ayhan Kose & Eswar Prasad & Marco Terrones, 2005. "How Do Trade and Financial Integration Affect the Relationship Between Growth and Volatility?," IMF Working Papers 05/19, International Monetary Fund. [Downloadable!]
    Other versions:
  9. Alessandra Bonfiglioli & Caterina Mendicino, 2004. "Financial Liberalization, Bank Crises and Growth: Assessing the Links," Economics Working Papers 946, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
    Other versions:
  10. Assaf Razin & Yona Rubinstein, 2005. "Evaluation of Currency Regimes: The Unique Role of Sudden Stops," NBER Working Papers 11785, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  11. Assaf Razin & Yona Rubinstein, 2004. "Growth Effects of the Exchange-Rate Regime and the Capital-Account Openness in A Crisis-Prone World Market: A Nuanced View," NBER Working Papers 10555, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  12. Charles Wyplosz, 2006. "Is East Asia Safe from Financial Crises?," HEI Working Papers 02-2007, Economics Section, The Graduate Institute of International Studies, revised Jan 2007. [Downloadable!]
  13. Joël van der Weele, 2005. "Financing development: debt versus equity," DNB Working Papers 038, Netherlands Central Bank, Research Department. [Downloadable!]
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