The crises of the 1990s have claimed many victims. Several countries around the world have experienced banking crises, roaring growing economies succumbed to their worst recession in decades, and the booming international capital flows of the early and mid 1990s have dwindled to a trickle. This is not all. Another important casualty of these crises has been the support for domestic and international liberalization of financial systems. In the aftermath of the Asian crisis, many voices were raised arguing that globalization had gone too far and had led to extremely erratic capital markets around the world. One of the most ardent defenders of the return to the old order of financial controls has been Joe Stiglitz (1999), who as the World Bank’s chief economist, clamored for developing countries to put some limits on capital inflows in order to moderate the “excessive” boom-bust pattern in financial markets. Even controls on capital outflows, not long ago dismissed as ineffective, have become fashionable again among some economists. Paul Krugman (1998), for instance, has argued that capital controls may help in managing, at least temporarily, an otherwise disorderly retreat of investors. With many more economists joining the ranks of those supporting intervention in financial markets (such as Eichengreen and Mussa 1998 and Rodrik 1998), long gone seem to be the days of an indiscriminate advocacy of more financial development.
Interestingly, in what it seems to be parallel world, many still praise the advantages of liberalization. They claim that financial liberalization can help improve the functioning of the financial system through increasing the availability of funds and allowing cross-country risk diversification. Moreover, as argued by Stulz (1999) and Mishkin (2001) among others, financial liberalization can help improve the financial infrastructure, reducing problems of asymmetric information, what decreases adverse selection and moral hazard and raises further the availability of credit. Furthermore, liberalization and the consequent development of a country’s financial sector tends to greatly facilitate economic growth, as shown in papers such as King and Levine (1993), Jayaratne and Strahan (1996), and Levine (2000). As the current of opinion that favors more repression, the group favoring deregulation has also been growing in numbers. See, for example, Rajan and Zingales (1998). The evidence on the benefits of financial deregulation also seems to be quite strong with, for example, output growth rates estimated to have increased about 1 percentage point following liberalization (as shown in Bekaert, Campbell, and Lundblad 2001).
These contradictory views in international economics are part and parcel of the two different views in the finance literature. The first group favors the view that stock and bond returns are essentially unpredictable. In this view, capital market theory is framed around two basic tenets: the random walk theory of stock prices and the expectations model of the term structure of bonds. Only one concession is made. With risk-averse investors, stock and bond returns could be time varying and predictable. Still, this predictability cannot be exploited to make a profit. That is, capital markets are efficient. Some of the empirical evidence in the last two decades seemed to have undermined these beliefs. Now, many economists are convinced that stock and bond returns are predictable at long horizons. They also believe that imperfections in asset markets trigger bubbles and protracted and predictable bull and bear markets. In explaining these phenomena, some authors, such as de Long et al. (1990), resort to asset pricing models based on noise trading or irrational behavior. Other authors incorporate some form of market imperfection. For example, Allen and Gorton (1993) construct a model in which an agency problem between investors and portfolio managers could produce bubbles, even though all participants are rational. Similarly, Allen, Morris, and Postlewaite (1993) develop a model where the absence of common knowledge leads to bubbles in asset prices.
The current of opinion in international economics that advocates deregulation of the domestic financial sector and the removal of capital controls endorses the view that either capital markets are efficient or restricting capital movement is inefficient. It is only with efficient markets that capital is allowed to flow to its most attractive destination once controls are removed. The view favoring controls or a very gradual liberalization argues that the elimination of restrictions on capital movement favors excesses. The arguments in the international literature as in the capital market literature rest on the idea that market failures and distortions pervade capital markets around the world.
One of the most often cited distortions in capital markets is that of information asymmetries. Information asymmetries are present in goods markets, but it is in asset markets that they become pronounced. In fact, asymmetric information is at the core of the existence of different agents in capital markets. (Banks, for example, exist because of their superior knowledge about the value of the firms to which they lend.) Moreover, many argue that problems of asymmetric information are more rampant in international capital markets, where geographical and cultural differences make harder the task of obtaining information. It is also in these markets that any imperfections can be magnified by the difficulties in enforcing contracts across borders. In this environment, investors may overreact to shocks, withdrawing massively from countries at the first signs of economic problems, or they may become euphoric and pour on capital in quantities beyond those justified by “good” fundamentals. This is the message of several theoretical papers emphasizing private or imperfect information. For example, Calvo and Mendoza (2000) argue that investors can become rationally “exuberant” in the presence of transaction costs and international capital market globalization. In particular, they argue that free international capital mobility, by increasing the menu of assets available to investors, promotes diversification. But diversification in a world with costly acquisition of country-specific information reduces the return in acquiring information about specific assets, aggravates imperfect information, promotes herding behavior, and triggers pronounced booms and crashes in financial markets.
While this conflicting debate is not a new one, there are still no signs of reconciliation of the opposite views and empirical evidence. A comprehensive set of theory and evidence, thus, should be able to explain both the links between financial liberalization and crises as well as the evidence that indicates that financial liberalization promotes growth. Naturally, the point of departure of any research should be focused on capital markets. One particular aspect that has not been investigated is the dynamic effect of financial deregulation, be it domestic or international on the functioning of capital markets. In our view, one way of making the conflicting evidence consistent with one another is to examine the possibility that financial deregulation triggers forces that favor more efficient financial markets over the long run, such as changes in institutions and accountability of investors. In this case, financial liberalization will promote growth. On impact, however, financial liberation may still trigger excesses, as protected and at the brink-of-default domestic financial institutions get access to government guaranteed international funding.
Since the evidence following crises is that of excessive booms and busts in the stock market, we examine the possible time-varying pattern of financial cycles before and after financial liberalization. To do so, we construct an anatomy of financial cycles in 28 emerging and mature markets. We look at the duration of upturns and downturns in financial markets, and the magnitude of the cycles, with particular attention to the possibility that the characteristics of the cycles have changed over time. This sets the groundwork for examining the effects of financial liberalization. Since there is no comprehensive data bank on the different aspects of financial liberalization (deregulation of the domestic financial industry, removal of controls on international capital flows, and the liberalization of the domestic stock market), we construct a new database for the 28 countries in our sample. This database on financial liberalization starts in 1973. By itself, this is an important contribution of our research.
Our main results can be summarized as follows. First, our data set on financial liberalization shows that since the 1970s countries around the world have liberalized their financial systems. Developed nations started the process earlier than less developed economies. Still, some Latin American countries experienced sharp liberalization processes in the late 1970s and early 1980s, but they closed their financial systems again after the debt crisis hit them. Following the crises of the 1990s, some countries also decided to revert the process of liberalization. The pattern of liberalization varies across regions, with developed countries liberalizing first their stock markets and developing economies opening first their domestic financial sector.
Second, stock market prices follow boom-bust patterns. These patterns are different from those generated by random walk processes in Monte Carlo experiments. As expected, booms and busts of stock market prices from developing countries are more pronounced than booms and busts of prices from developed economies.
Third, with regard to the possible changing nature of financial cycles and in particular the seemingly explosive nature of financial cycles in the 1990s, our analysis shows that financial cycles have not intensified after financial liberalization. In fact, stock market cycles become smoother after financial liberalization.
Fourth, when we compare cycles in episodes of regulated domestic and external financial markets and episodes of full liberalization, we find that financial liberalization does tend to trigger more explosive financial cycles in the short run. Within three years, financial cycles become less pronounced. Interestingly, these findings apply to both emerging and mature markets.
The rest of the paper is organized as follows. Section II presents the new data on financial liberalization and examines the patterns of deregulation since 1973. Section III characterizes booms and crashes in the different regions and examines whether financial downturns and upturns have become more extreme. Section IV examines whether domestic financial liberalization and capital controls can explain the standard features of financial cycles in the different regions and over time. Section V concludes and discusses ideas for future research.
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