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

  • Katherine A. Smith

    (U.S. Naval Academy)

  • Enrique G. Mendoza

    (University of Maryland and NBER)

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

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Date of creation: 2011
Date of revision:
Handle: RePEc:red:sed011:235
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  1. Ceyhun Bora Durdu & Enrique G. Mendoza & Marco E. Terrones, 2007. "Precautionary demand for foreign assets in sudden stop economies: an assessment of the new mercantilism," International Finance Discussion Papers 911, Board of Governors of the Federal Reserve System (U.S.).
  2. Ceyhun Bora Durdu & Enrique G. Mendoza, 2005. "Are Asset Price Guarantees Useful for Preventing Sudden Stops?: A Quantitative Investigation of the Globalization Hazard-Moral Hazard Tradeoff," NBER Working Papers 11178, National Bureau of Economic Research, Inc.
  3. Lane, Philip R. & Milesi-Ferretti, Gian Maria, 2006. "The External Wealth of Nations Mark II: Revised and Extended Estimates of Foreign Assets and Liabilities, 1970-2004," CEPR Discussion Papers 5644, C.E.P.R. Discussion Papers.
  4. Laura Alfaro & Fabio Kanczuk, 2007. "Optimal Reserve Management and Sovereign Debt," NBER Working Papers 13216, National Bureau of Economic Research, Inc.
  5. 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.
  6. David K. Backus & Allan W. Gregory & Stanley E. Zin, 1986. "Risk Premiums in the Term Structure : Evidence from Artificial Economies," Working Papers 665, Queen's University, Department of Economics.
  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. 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.
  9. 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.
  10. 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.
  11. 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.
  12. Ricardo J. Caballero & Stavros Panageas, 2003. "Hedging Sudden Stops and Precautionary Contractions," NBER Working Papers 9778, National Bureau of Economic Research, Inc.
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