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Rethinking the Effects of Financial Liberalization

  • Fernando Broner and Jaume Ventura

During the last few decades, many emerging markets have lifted restrictions on cross-border financial transactions. The conventional view was that this would allow these countries to: (i) receive capital in flows from advanced countries that would finance higher investment and growth; (ii) insure against aggregate shocks and reduce consumption volatility; and (iii) accelerate the development of domestic financial markets and achieve a more effcient domestic allocation of capital and better sharing of individual risks. However, the evidence suggests that this conventional view was wrong. Inthispaper, we present a simple model that can account for the observed effects of financial liberalization. The model emphasizes the role of imperfect enforcement of domestic debts and the interactions between domestic and international financial transactions. In the model, financial liberalization might lead to different outcomes: (i) domestic capital flight and ambiguous effects on net capital fl0ows, investment, and growth; (ii) large capital inflows and higher investment and growth; or (iii) volatile capital flows and unstable domestic financial markets. The model shows how these outcomes depend on the level of development, the depth of domestic financial markets, and the quality of institutions.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 509.

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Date of creation: Oct 2010
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Handle: RePEc:bge:wpaper:509
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