Working Paper: CEPR ID: DP3378
Authors: Philippe Martin; Helene Rey
Abstract: We analyse the impact of financial globalization on asset prices, investment and the possibility of crashes driven by self-fulfilling expectations in emerging markets. In a two-country model with one emerging market (intermediate income level) and one industrialized country (high income level), we show that symmetric liberalization of capital outflows and inflows increases asset prices, investment and income in the emerging market. For intermediate levels of international financial transaction costs, however, we find that pessimistic expectations can be self-fulfilling, leading to a financial crash. The crash is accompanied by capital flight, a drop in income and investment below the financial autarky level and more market incompleteness. We show that emerging markets are more prone to such a financial crash simply because they have a lower income level and not because of the existence of market failures (moral hazard or credit constraints), bad monetary policies or exchange rate regimes.
Keywords: Emerging Markets; Financial Crises; Financial Globalization
JEL Codes: F32; F36; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| symmetric liberalization of capital outflows and inflows (F32) | asset prices (G19) |
| symmetric liberalization of capital outflows and inflows (F32) | investment (G31) |
| symmetric liberalization of capital outflows and inflows (F32) | income (E25) |
| pessimistic expectations (D84) | self-fulfilling financial crashes (G01) |
| self-fulfilling financial crashes (G01) | capital flight (F21) |
| self-fulfilling financial crashes (G01) | drop in income (E25) |
| self-fulfilling financial crashes (G01) | drop in investment (E22) |
| lower income levels (I32) | vulnerability to financial crashes (G01) |