Economic Volatility and Capital Account Liberalization in Emerging Countries

Abstract

Economic volatility has increased drastically in the age of financial liberalization. The tendency among mainstream economists has been to explain this trend by government misdeeds and various market imperfections. For instance, government overspending was the main culprit in the first generation models of currency crises. Following the Asian crisis the emphasis shifted onto capital flow reversals, and arguments based on the ‘moral hazard’ problems began to replace the emphasis on the monetized government deficits. This paper outlines an explanation of economic volatility that is not based on moral hazard problems or other market distortions. Two stylized facts associated with the aftermath of financial and capital account liberalization are singled out for emphasis and brought together in the context of a macroeconomic framework that draws from Keynes’ Treatise. These are: (i) liquidity preference becomes intertwined with currency substitution, producing a macroeconomic destabilizer that explains procyclical changes in bank credit independently of moral hazard problems; and (ii) asset prices become fairly easy to predict, stimulating destabilizing ‘trend’ speculation by foreign investors, which means that profit seeking and market rationality might lie behind erratic shifts in capital flows.Economic volatility, financial liberalization, currency crises, capital flows, asset price speculation, E12, E44, F32, F41,

Capital Flows and Financial Stability in Emerging Economies

“…The effect of capital flows on financial stability in emerging markets has gained interest for its potential consequences for macroeconomic stability as recent crises have revealed (Erturk 2005;and Kaminsky and Reinhart 1999). Some believe that financial liberalization in developing economies (domestic deregulation and opening of the capital account) is followed by instability and crises for reasons such as underdeveloped institutions and banking systems, and an increase in competition and risk-taking as the process of liberalization evolves (Corsetti, Pesenti, and Roubini 1999;and Daniel and Jones 2007).…”

International Business Risk Management and the Emerging Market Crises as Challenges for the UN Global Compact

“…Especially after the Asian crisis in the era of liberalization the emphasis in the emerging market currency crises investigation shifted on to the capital flow reversals, as argued by Erturk (2005). Moreover, when the devaluation risk rose with the excessive borrowing, the capital inflow declined before foreign reserves were depleted and the foreign exchange and capital movement constrains were imposed.…”

The Measure of Financial Stability and its Impact on Foreign Direct Investment: Evidence from BRIC Nations

“…This is because if they bring the much-sought foreign capital into an economy to support its growth, they also render vulnerability to the economy by exposing its financial and economic systems to external shocks (Kim & Singal, 2000). Unsurprisingly, there is an enhanced interest in determining the relationship between financial stability and capital flows owing to their potential impact on macroeconomic stability as emphasized in the recent crisis episodes of past (Erturk, 2005). On one hand, the literature argues that financial liberalization realized through opening of capital accounts and domestic deregulations renders the economy unstable leading to crisis even.…”