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Financial Globalization, Financial Crisis, and the External Capital Structure of Emerging Markets

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  • Katherine A. Smith

    (U.S. Naval Academy)

  • Enrique G. Mendoza

    (University of Maryland and NBER)

Abstract

This paper argues that credit frictions and asset trading costs signigcantly increase the probability of a Sudden Stop in the early stages of financial globalization, and that this in turn, significantly alters the long-run external capital structure of emerging market economies. Upon opening the capital account, domestic agents have an incentive to accumulate debt and sell domestic equity in order to share risk with the rest of the world. Due to a lower cost of capital, equity prices rise allowing agents to accumulate a relatively large amount of debt without being constrained in the near term. As domestic agents accumulate debt and sell equity to re-balance their portfolio, however, adjustment costs force equity prices to subsequently fall. With a lower value of equity, agents within the emerging economy face a greater risk of hitting their credit constraint, triggering a debt deflation crisis. In the long run, the probability of a Sudden Stop is smaller as agents accumulate pre-cautionary savings to avoid the Sudden Stop. However, the adjustment of the external capital structure is permanent. Calibrating the model to Mexico, we solve numerically for the transitional dynamics after nancial globalization and show that the model can match the dynamics observed in the data.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 235.

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Date of creation: 2011
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Handle: RePEc:red:sed011:235

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  1. Enrique G. Mendoza & Ceyhun Bora Durdu, 2006. "Are Asset Price Guarantees Useful for Preventing Sudden Stops? A Quantitative Investigation of the Globalization Hazard-Moral Hazard Tradeoff," IMF Working Papers 06/73, International Monetary Fund.
  2. Philip R. Lane & Gian-Maria Milesi-Ferretti, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004," IMF Working Papers 06/69, International Monetary Fund.
  3. Enrique G. Mendoza & Katherine A. Smith, 2004. "Quantitative Implication of A Debt-Deflation Theory of Sudden Stops and Asset Prices," NBER Working Papers 10940, National Bureau of Economic Research, Inc.
  4. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 371-399, November.
  5. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  6. Marco E. Terrones & Enrique G. Mendoza & Ceyhun Bora Durdu, 2008. "Precautionary Demand for Foreign Assets in Sudden Stop Economies: An Assessment of the New Mercantilism," 2008 Meeting Papers 56, Society for Economic Dynamics.
  7. Graciela L. Kaminsky & Carmen M. Reinhart, 1996. "The twin crises: the causes of banking and balance-of-payments problems," International Finance Discussion Papers 544, Board of Governors of the Federal Reserve System (U.S.).
  8. Caballero, Ricardo J. & Panageas, Stavros, 2008. "Hedging sudden stops and precautionary contractions," Journal of Development Economics, Elsevier, vol. 85(1-2), pages 28-57, February.
  9. Alfaro, Laura & Kanczuk, Fabio, 2009. "Optimal reserve management and sovereign debt," Journal of International Economics, Elsevier, vol. 77(1), pages 23-36, February.
  10. Sunil Sharma & Woon Gyu Choi & Maria Strömqvist, 2007. "Capital Flows, Financial Integration, and International Reserve Holdings: The Recent Experience of Emerging Markets and Advanced Economies," IMF Working Papers 07/151, International Monetary Fund.
  11. Peter Blair Henry, 2000. "Stock Market Liberalization, Economic Reform, and Emerging Market Equity Prices," Journal of Finance, American Finance Association, vol. 55(2), pages 529-564, 04.
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