During the last few decades, emerging markets have lifted most restrictions on international asset trade. The conventional view was that (i) capital would flow into these countries raising investment and growth; (ii) these countries would use international capital markets to smooth productivity, terms-of-trade, and other shocks and achieve less volatile consumption; and (iii) financial integration would encourage the development of domestic financial markets, leading to a more efficient domestic allocation of capital and better sharing of individual risks. But in those emerging markets that liberalized their financial markets, average net capital flows have been small and even negative, volatile and procyclical. As a result, (i) investment and growth have not only not increased but even declined in some cases; (ii) consumption has become more volatile; and (iii) domestic financial markets have become unstable and prone to crises. In this paper, we present a simple model of financial liberalization that can account for these observations. The key friction in the model is sovereign risk. What makes this model different from previous models of sovereign risk is the existence of gains from domestic asset trade and that governments cannot discriminate between domestic and foreign creditors when enforcing debt payments. This makes the theory more realistic both in terms of assumptions and results.
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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number
1128.
Find related papers by JEL classification: F34 - International Economics - - International Finance - - - International Lending and Debt Problems F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
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