Working Paper: NBER ID: w19072
Authors: Enrique G. Mendoza; Katherine A. Smith
Abstract: We study the short- and long-run effects of financial integration in emerging economies using a two-sector model with a collateral constraint on external debt and trading costs incurred by foreign investors. The probability of a financial crisis displays overshooting: It rises sharply initially and then falls sharply but remains positive in the long run. While equity holdings fall permanently, bond holdings initially fall but rise after the crisis probability peaks. Conversely, asset returns and asset prices first rise and then fall. These results are in line with the post-globalization dynamics observed in emerging markets, and the higher frequency of crises they displayed. Without financial frictions, the model yields a negligible fall in equity and a large increase in debt. The results also depend critically on supply-side effects of financial frictions affecting the price of nontradables and dividends from nontradables producers, and on strong precautionary savings incentives induced by the risk of financial crises.
Keywords: financial globalization; financial crises; emerging markets; external portfolio structure
JEL Codes: D52; E44; F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial integration (F30) | increase in asset returns (G19) |
| financial integration (F30) | decline in asset returns (G19) |
| financial integration (F30) | increase in crisis probability (H12) |
| financial crises (G01) | decrease in equity holdings (G32) |
| financial crises (G01) | increase in bond holdings (G12) |
| increase in crisis probability (H12) | rebalancing of portfolios (G11) |
| rebalancing of portfolios (G11) | decrease in equity holdings (G32) |
| rebalancing of portfolios (G11) | increase in bond holdings (G12) |
| financial integration (F30) | overshooting of crisis probability (E37) |
| financial integration (F30) | permanent decrease in equity holdings (G32) |
| financial integration (F30) | increase in debt holdings (H63) |