Financial liberalizations in emerging markets are often followed by reckless lending and severe banking crises. The identification of the causes of banks’ behavior is often difficult because financial liberalizations entail several contemporaneous changes. Competition in the banking sector increases, and, at the same time, the liberalization of the current account allows capital inflows.
The existing literature has mainly stressed the first of these changes: Among others, Hellmann et al. (2000) and Allen and Gale (2000) have analyzed how competition affects banks’ incentives to risk-taking. The argument goes as follows: Competition in the market for deposits increases banks’ cost of funds and gives an incentive to select riskier projects (to shift risk on depositors).
The sequence of financial crises that started with the so-called Tequila crisis in Mexico in 1994-95 strongly suggests that these phenomena cannot simply be rationalized in terms of advanced-country business cycle models. More is at stake here. In particular, these episodes are associated with a sharp contraction of international capital flows, or Sudden Stop, which may by itself have triggered the ensuing disruption. Sudden Stops are associated with large depreciations and major financial disruptions, leading to significantly lower rates of return, investment and growth. This is the point of view that will be elaborated on and subjected to empirical analysis in the present paper.
For starters, we would like to say a few words on alternative explanations of deep financial crises in Emerging Market economies (EMs) and give an intuitive presentation of the approach pursued in this paper. A popular explanation for these crises used to be and, in some quarters still is, “lack of fiscal discipline.” As the argument goes, crisis-prone EMs have a tendency to run high fiscal deficits, which eventually result in an unsustainable level of public debt. Thus, there comes a time when lenders stop lending, forcing a major domestic adjustment. This explanation is very appealing for the 1980s Debt Crisis in Latin America, but finds little support in Asia. For example, at the inception of its 1997 crisis, Korea’s public debt hovered around only 10 percent of GDP. Moreover, debt levels in EMs are comparable to if not significantly lower than in advanced countries (e.g., Japan).
This paper studies the driving forces of business cycles within and across G-7 countries over the period 1961 to 2005. We use the term driving forces in the same manner it is employed in dynamic rational expectations models of the international business cycle variables taken to be exogenous in the model employed by the researcher. Most published work focuses on a single driving variable in isolation with the world divided into home and foreign locations. The most common driving variables are total factor productivity and monetary and fiscal policy shocks.
