Financial Globalization, Financial Crisis, and the External Capital Structure of Emerging Markets

Katherine A. Smith and Enrique Mendoza
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Katherine A. Smith: U.S. Naval Academy

No 235, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: This paper argues that credit frictions and asset trading costs signigcantly increase the probability of a Sudden Stop in the early stages of financial globalization, and that this in turn, significantly alters the long-run external capital structure of emerging market economies. Upon opening the capital account, domestic agents have an incentive to accumulate debt and sell domestic equity in order to share risk with the rest of the world. Due to a lower cost of capital, equity prices rise allowing agents to accumulate a relatively large amount of debt without being constrained in the near term. As domestic agents accumulate debt and sell equity to re-balance their portfolio, however, adjustment costs force equity prices to subsequently fall. With a lower value of equity, agents within the emerging economy face a greater risk of hitting their credit constraint, triggering a debt deflation crisis. In the long run, the probability of a Sudden Stop is smaller as agents accumulate pre-cautionary savings to avoid the Sudden Stop. However, the adjustment of the external capital structure is permanent. Calibrating the model to Mexico, we solve numerically for the transitional dynamics after nancial globalization and show that the model can match the dynamics observed in the data.

Date: 2011
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