The Positive Link Between Financial Liberalization, Growth and Crises

Abstract

There is no agreement regarding the growth-enhancing effects of financial liberalization, mainly because it is associated with risky international bank flows, lending booms, and crises. In this paper we make the case for liberalization despite the occurrence of crises. We show that in developing countries trade liberalization has typically been followed by financial liberalization, which has indeed led to financial fragility and a greater incidence of crises. However, financial liberalization also has led to higher GDP growth. In fact, the fastest-growing countries are typically those that have experienced boom-bust cycles. That is, there is a positive link between GDP growth and the bumpiness of credit, which is captured by the negative skewness --not by the variance--of credit growth. To substantiate our interpretation of the data we present a model that shows why in countries with severe credit market imperfections, liberalization leads to higher growth and, as a byproduct, to financial fragility. Thus, occasional crises need not forestall growth and may even be a necessary component of a developing country's growth experience. Finally, our analysis indicates that foreign direct investment does not obviate the need for risky international bank flows, as the latter are the only source of financing for most firms in the nontradables sector.

Financial development and financial liberalization in Asia: Thresholds, institutions and the sequence of liberalization

“…Aizenman and Noy (2004) find that financial openness and trade openness are bidirectional, though financial openness seems to lead to trade openness more than the other way around. Tornell et al (2004) also show that financial liberalization has typically followed trade liberalization over the last two decades.…”

Two to tangle: Financial development, political instability and economic growth in Argentina

“…Thereby using a range of measures of financial development we throw light on the impacts of these different measures over a much longer period of time than normally considered in the current literature. In addition to whether finance affects growth directly or through growth volatility, another important issue we tackle is that identified by Kaminsky and Schmukler (2003), Tornell et al (2004) and Loayza and Ranciere (2006).…”

The Relevance of Foreign Ownership and Financial Liberalization for Determining Banking Risk: A Comparative Analysis of European Countries

“…Cubillas and gonzález [2014] indicate that financial liberalization implies stronger competition in the banking sector that increases bank risk by expanding possibility in emerging countries and increases risk-taking encouragements in high developed countries. As opposite, the literature on boom-bust cycles suggests that financial liberalization increases banking risk by undertaking riskier investments much more in less economically and developed countries [Tornell, Westermann, Martinez, 2004].…”