Working Paper: CEPR ID: DP1889
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: The paper analyses the impact of financial liberalization and reform in emerging markets on the dynamics of capital flows to these markets, using a simple model of international investors? behaviour. We first show that the gradual nature of liberalization, combined with the cost of absorbing large inflows in emerging eonomies, leads to rich dynamics of capital flows and often implies an initial period of overshooting as portfolios adjust. Asset prices will also overshoot. Second, we show that, if investors have incomplete information about new emerging markets, and learn over time, there can be high volatility of capital flows and contagion. Finally, we provide numerical estimates of long-run capital inflows to emerging market economies and compare them to actual inflows. This gives a good indicator of upcoming crisis situations.
Keywords: emerging markets; volatility; liberalization
JEL Codes: F21; F32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| gradual financial liberalization (F30) | overshooting in capital flows (F32) |
| gradual financial liberalization (F30) | overshooting in asset prices (G19) |
| incomplete information about liberalization (P33) | high volatility in capital flows (F32) |
| incomplete information about liberalization (P33) | potential for contagion among emerging markets (F65) |
| portfolio adjustments (G11) | nonlinear relationship between capital flows and liberalization (F32) |
| gradual financial liberalization (F30) | volatility in capital flows (F32) |