Financial Globalization and Emerging Markets: With or Without Crash?

We analyze the impact of ...nancial globalization on asset prices, investment and the possibility of crashes driven by self-ful...lling 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 out‡ows and in‡ows increases asset prices, investment and income in the emerging market. However, for intermediate levels of international ...nancial transaction costs, we ...nd that pessimistic expectations can be self-ful...lling, leading to a ...nancial crash. The crash is accompanied by capital ‡ight, a drop in income and investment below the ...nancial autarky level and more market incompleteness. We show that emerging markets are more prone to ...nancial crashes 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. ¤International Research, Federal Reserve Bank of New York, 33 Liberty Street, NY, NY 10045. Telephone: (001) 212 720 54 97. E-mail: [email protected]. ¤¤Department of Economics and Woodrow Wilson School, Princeton University, Princeton, NY , USA. Telephone: (001) 609 258 6726. E-mail: [email protected]. The views expressed here are those of the authors, and do not necessarily re‡ect the position of the Federal Reserve Bank of New York, the Federal Reserve System, or any other institution with which the authors are a¢liated. We thank Daniel Cohen, Gene Grossman, Enrique Mendoza and Aaron Tornell as well as participants at many seminars for helpful comments. We also thank Graciela Kaminsky and Sergio Schmukler for the stock market data. Rachel Polimeni provided excellent research assistance. This paper is part of a research network on ‘The Analysis of International Capital Markets: Understanding Europe’s Role in the Global Economy’, funded by the European Commission under the Research Training Network Programme (Contract No. HPRNŒCTŒ1999Œ00067).