The crises of the 1990s in Asia, Europe, and Latin America have re-ignited the debate on the effects of financial liberalization. Many argue that the deregulation of financial markets was the main trigger of many of the crises observed since the 1970s. The evidence supports this claim. For example, Kaminsky and Reinhart (1999) find that the likelihood of banking crises increases by 40 percent following the deregulation of the domestic banking sector. They also find that crises are preceded by a sharp increase in the bank credit-to-GDP ratio and by a boom bust cycle in stock prices, about 50 percent higher than those observed in non-crisis times. A variety of models have been proposed to explain this link. For example, Allen and Gale (1999, 2000), Hellman et al. (2000), and Schneider and Tornell (2004), among others, show that financial liberalization leads to risky behavior by banks. Moreover, Tornell and Westermann (2005) argue that financial liberalization triggers lending boom-bust cycles in economies with credit restrictions and overall imperfections in financial markets. Allen and Gale (2000) further show that these lending booms can feed into stock market bubbles because agency problems generate an incentive for borrowers to use bank loans to buy risky assets, with these bubbles ending up in banking crises and recessions. Overall, these models rest on the idea that market failures and distortions pervade capital markets and are the sources of the boom-bust patterns.
Other authors, in contrast, highlight the benefits of financial liberalization. They claim that financial liberalization allows capital to move to its most attractive destination, increasing productivity and growth and fostering a better functioning of financial markets. For example, Bekaert et al. (2005a, b) find that liberalization leads to a one-percentage point increase in annual economic growth as well as to a decline in output volatility. Also, Henry (2000a, b) finds that liberalization triggers an increase in the investment rate and a substantial revaluation of equity prices in a large number of countries. Traditional neoclassical models provide the theoretical support for these findings. In these models, financial liberalization reduces the cost of capital and fuels a significant boom in lending and stock market prices, but does not trigger a financial crash.
While the empirical research on the effects of financial liberalization has grown significantly during the last two decades, the evidence overall is still quite inconclusive, with some studies supporting the link between liberalization and crises and others backing the traditional neoclassical view. In our view, these seemingly conflicting findings can still be consistent with one another if financial deregulation triggers forces that favor more efficient financial markets over the long run, such as improvements in institutions and accountability of investors. In this case, financial liberalization eventually promotes more stable financial markets and growth. On impact, however, financial liberation may still trigger short-run financial booms and busts and output collapses in economies with distortions in capital markets as protected domestic financial institutions obtain access to new funds.
In this paper, we study the effects of financial liberalization in a varied group of countries. Since the quality of government institutions and general distortions in capital markets are at the core of the conflicting views on the effects of financial liberalization, we cast our net wide and include economies with different degrees of institutional and economic development. Our sample comprises twenty-eight emerging- and mature-market economies. We classify the sample into four (mostly regional) country groupings: the G-7 countries, which are comprised of Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States; the Asian region, which includes Hong Kong, Indonesia, Malaysia, the Philippines, (South) Korea, Taiwan, and Thailand; the European group, which excludes those countries that are part of the G-7, and includes Denmark, Finland, Ireland, Norway, Portugal, Spain, and Sweden; and the Latin American sample, which consists of the largest economies in the region, Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela.
Since the chronologies of financial liberalization are still quite fragmented, we construct a new database that captures the main aspects of liberalization (deregulation of the domestic banking industry, removal of controls on international capital flows, and the liberalization of the domestic stock market) for the twenty-eight countries in our sample between 1973 and 2005. This sample gives us the opportunity to study 63 episodes of liberalization of the banking industry, 67 episodes of opening up of the capital account, and 49 episodes of deregulation of the stock market. By itself, this new chronology is an important contribution of this paper.
As suggested by the various families of models in the literature, a natural point of departure of any empirical research on financial liberalization should be capital markets. This is also our focus. Since the research on currency and banking crises indicates that crisis episodes are preceded by booms and crashes in stock markets, we first examine whether stock prices follow in fact boom-bust patterns by using an algorithm that replicates the NBER methodology to identify business cycles. Our results indicate that cycles characterize the behavior of stock prices in our sample. We then look at the magnitude of the upturns and downturns, 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.
We compare the behavior of financial cycles during repression, in the aftermath of financial liberalization, and (if liberalization persists) in the long run following liberalization. Our results for emerging markets indicate that there is a quite pronounced time-varying relation between liberalization and financial market cycles. We find that liberalization is followed by substantially more pronounced booms and crashes in the short run, which supports the models in which financial liberalization triggers risky behavior and excesses in financial markets. In contrast, we find that in the long run, financial cycles become less pronounced, perhaps because capital market distortions become less widespread. These results are robust to controls suggested by theory. Our findings for mature markets support the view that liberalization leads to an increase in the value of the firms, but not to larger crashes even in the immediate aftermath of financial liberalization.
Our results on the time-varying pattern on stock market cycles in emerging economies suggest that government reforms may not predate financial liberalization. To examine this issue, we collect data on the quality of government institutions as well as on the laws governing the proper functioning of financial systems and examine the timing of financial liberalization and institutional reforms. Interestingly, we find that government reforms mostly occur following, not before, financial liberalization, suggesting that liberalization sets in motion the reforms needed for markets to operate efficiently, as indicated in Mishkin (2003) and Stultz (2005). Moreover, our results suggest that financial cycles become less pronounced after improvements in property rights, transparency, and overall contractual environment.
The rest of the paper is organized as follows. Section 2 describes the new chronology on financial liberalization for the twenty-eight countries in our sample for the period 1973-2005. Section 3 identifies stock price cycles and studies the relation between financial liberalization and the time-varying behavior of financial cycles. Section 4 examines the dynamics between financial liberalization and institutional reforms. Section 5 concludes.
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