Liquidity, volatility and growth

This paper studies the relation between average growth and growth volatility. To do so a two period model is built which focuses on how firms choose their debt portfolio maturity. Due to imperfect enforceability problems, we show that contracts financing long-term investments are biased towards short-term debt. This can generate maturity mismatches between assets and liabilities and lead to liquidity crises. Then it is shown that the relation between average growth and growth volatility is more likely to be negative in developing countries, i.e. economies where financial intermediaries assets are relatively small compared to the rest of the economy while it is more likely to be positive in developed economies, i.e. economies where financial intermediaries assets are relatively large compared to the rest of the economy. We therefore invalidate the idea that volatility is the price for rapid growth in emerging market countries. This framework also allows us to assess the impact of foreign direct investment (FDI) and financial opening (FO). We show that FDI has stabilizing effects in developing economies while FO has destabilizing effects. On the contrary in developed economies FO has stabilizing effects.