Short-Run Pain, Long-Run Gain: Financial Liberalization and Stock Market Cycles

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1 Short-Run Pan, Long-Run Gan: Fnancal Lberalzaton and Stock Market Cycles Gracela Laura Kamnsky George Washngton Unversty and NBER Washngton, DC Sergo L. Schmukler * World Bank Washngton, DC December 2007 Abstract The vews on fnancal lberalzaton are qute conflctve. Many argue that t trggers fnancal bubbles and crses. Others clam that fnancal lberalzaton allows markets to functon properly and captal to move to ts most proftable destnaton. The emprcal evdence on these effects s not robust. Ths paper constructs a new comprehensve chronology of fnancal lberalzaton and shows that a key reason for the nconclusve evdence s that the effects of lberalzaton are tme-varyng. Fnancal lberalzaton s followed by large booms and busts only n the short run. In the long run, nsttutons mprove and fnancal markets tend to stablze. JEL classfcaton codes: F, F36, G12, G15 Keywords: fnancal ntegraton, globalzaton, stock market prces, booms, busts, fnancal cycles We have receved nsghtful comments from Frankln Allen (the Edtor), Tom Glaessner, Gan Mara Mles- Ferrett, Raghu Rajan, Lnda Tesar, Aaron Tornell, two anonymous referees, as well as partcpants at presentatons held at the Amercan Economc Assocaton Meetngs, Brandes Unversty, the Deutsche Bundesbank, the Federal Reserve Bank of New York, the Federal Reserve Board, the Internatonal Monetary Fund, the Socety for Economc Dynamcs Meetng (New York Unversty), the LACEA Annual Meetngs (Madrd), Stanford Unversty, Unversty of Maryland, Unversdad Torcuato D Tella, and the World Bank. We are grateful to José Azar, Francsco Ceballos, Tatana Dder, Juan Carlos Gozz, Federco Guerrero, Marna Halac, Ccla Harun, José Pneda, Arun Sharma, Akko Terada, Francsco Vazquez, Chrs van Klaveren, and Kevn Wang, who helped us wth excellent research assstance at dfferent stages of the project. The Research Commttee and the Latn Amercan Regonal Studes Program of the World Bank kndly provded fnancal support. The vews expressed n ths paper are those of the authors and should not be nterpreted as reflectng those of the World Bank. Correspondng author: Gracela L. Kamnsky, Department of Economcs, George Washngton Unversty, Washngton, DC 2; phone: (202) ; Fax: (202) ; emal: gracela@gwu.edu.

2 1. Introducton The crses of the 1990s n Asa, Europe, and Latn Amerca have re-gnted the debate on the effects of fnancal lberalzaton. Many argue that the deregulaton of fnancal markets was the man trgger of many of the crses observed snce the 19s. The evdence supports ths clam. For example, Kamnsky and Renhart (1999) fnd that the lkelhood of bankng crses ncreases by 40 percent followng the deregulaton of the domestc bankng sector. They also fnd that crses are preceded by a sharp ncrease n the bank credt-to-gdp rato and by a boombust cycle n stock prces, about 50 percent hgher than those observed n non-crss tmes. A varety of models have been proposed to explan ths lnk. For example, Allen and Gale (1999, 2000), Hellman et al. (2000), and Schneder and Tornell (2004), among others, show that fnancal lberalzaton leads to rsky behavor by banks. Moreover, Tornell and Westermann () argue that fnancal lberalzaton trggers lendng boom-bust cycles n economes wth credt restrctons and overall mperfectons n fnancal markets. Allen and Gale (2000) further show that these lendng booms can feed nto stock market bubbles because agency problems generate an ncentve for borrowers to use bank loans to buy rsky assets, wth these bubbles endng up n bankng crses and recessons. Overall, these models rest on the dea that market falures and dstortons pervade captal markets and are the sources of the boom-bust patterns. 1 Other authors, n contrast, hghlght the benefts of fnancal lberalzaton. They clam that fnancal lberalzaton allows captal to move to ts most attractve destnaton, ncreasng productvty and growth and fosterng a better functonng of fnancal markets. For example, Bekaert et al. (a, b) fnd that lberalzaton leads to a one-percentage pont ncrease n annual 1 For other explanatons, see Bachetta and van Wncoop (2000), Krugman (1995, 1998), McKnnon and Pll (), and Stulz (), among others, as well as the more detaled dscusson summarzed n Secton III. 1

3 economc growth as well as to a declne n output volatlty. Also, Henry (2000a, b) fnds that lberalzaton trggers an ncrease n the nvestment rate and a substantal revaluaton of equty prces n a large number of countres. Tradtonal neoclasscal models provde the theoretcal support for these fndngs. In these models, fnancal lberalzaton reduces the cost of captal and fuels a sgnfcant boom n lendng and stock market prces, but does not trgger a fnancal crash. Whle the emprcal research on the effects of fnancal lberalzaton has grown sgnfcantly durng the last two decades, the evdence overall s stll qute nconclusve, wth some studes supportng the lnk between lberalzaton and crses and others backng the tradtonal neoclasscal vew. In our vew, these seemngly conflctng fndngs can stll be consstent wth one another f fnancal deregulaton trggers forces that favor more effcent fnancal markets over the long run, such as mprovements n nsttutons and accountablty of nvestors. In ths case, fnancal lberalzaton eventually promotes more stable fnancal markets and growth. On mpact, however, fnancal lberaton may stll trgger short-run fnancal booms and busts and output collapses n economes wth dstortons n captal markets as protected domestc fnancal nsttutons obtan access to new funds. In ths paper, we study the effects of fnancal lberalzaton n a vared group of countres. Snce the qualty of government nsttutons and general dstortons n captal markets are at the core of the conflctng vews on the effects of fnancal lberalzaton, we cast our net wde and nclude economes wth dfferent degrees of nsttutonal and economc development. Our sample comprses twenty-eght emergng- and mature-market economes. We classfy the sample nto four (mostly regonal) country groupngs: the G-7 countres, whch are comprsed of Canada, France, Germany, Italy, Japan, the Unted Kngdom, and the Unted States; the Asan regon, whch ncludes Hong Kong, Indonesa, Malaysa, the Phlppnes, (South) Korea, Tawan, 2

4 and Thaland; the European group, whch excludes those countres that are part of the G-7, and ncludes Denmark, Fnland, Ireland, Norway, Portugal, Span, and Sweden; and the Latn Amercan sample, whch conssts of the largest economes n the regon, Argentna, Brazl, Chle, Colomba, Mexco, Peru, and Venezuela. Snce the chronologes of fnancal lberalzaton are stll qute fragmented, we construct a new database that captures the man aspects of lberalzaton (deregulaton of the domestc bankng ndustry, removal of controls on nternatonal captal flows, and the lberalzaton of the domestc stock market) for the twenty-eght countres n our sample between 1973 and. Ths sample gves us the opportunty to study 63 epsodes of lberalzaton of the bankng ndustry, 67 epsodes of openng up of the captal account, and 49 epsodes of deregulaton of the stock market. By tself, ths new chronology s an mportant contrbuton of ths paper. As suggested by the varous famles of models n the lterature, a natural pont of departure of any emprcal research on fnancal lberalzaton should be captal markets. Ths s also our focus. Snce the research on currency and bankng crses ndcates that crss epsodes are preceded by booms and crashes n stock markets, we frst examne whether stock prces follow n fact boom-bust patterns by usng an algorthm that replcates the NBER methodology to dentfy busness cycles. Our results ndcate that cycles characterze the behavor of stock prces n our sample. We then look at the magntude of the upturns and downturns, wth partcular attenton to the possblty that the characterstcs of the cycles have changed over tme. Ths sets the groundwork for examnng the effects of fnancal lberalzaton. We compare the behavor of fnancal cycles durng represson, n the aftermath of fnancal lberalzaton, and (f lberalzaton perssts) n the long run followng lberalzaton. Our results for emergng markets ndcate that there s a qute pronounced tme-varyng relaton 3

5 between lberalzaton and fnancal market cycles. We fnd that lberalzaton s followed by substantally more pronounced booms and crashes n the short run, whch supports the models n whch fnancal lberalzaton trggers rsky behavor and excesses n fnancal markets. In contrast, we fnd that n the long run, fnancal cycles become less pronounced, perhaps because captal market dstortons become less wdespread. These results are robust to controls suggested by theory. Our fndngs for mature markets support the vew that lberalzaton leads to an ncrease n the value of the frms, but not to larger crashes even n the mmedate aftermath of fnancal lberalzaton. Our results on the tme-varyng pattern on stock market cycles n emergng economes suggest that government reforms may not predate fnancal lberalzaton. To examne ths ssue, we collect data on the qualty of government nsttutons as well as on the laws governng the proper functonng of fnancal systems and examne the tmng of fnancal lberalzaton and nsttutonal reforms. Interestngly, we fnd that government reforms mostly occur followng, not before, fnancal lberalzaton, suggestng that lberalzaton sets n moton the reforms needed for markets to operate effcently, as ndcated n Mshkn (2003) and Stultz (). Moreover, our results suggest that fnancal cycles become less pronounced after mprovements n property rghts, transparency, and overall contractual envronment. The rest of the paper s organzed as follows. Secton 2 descrbes the new chronology on fnancal lberalzaton for the twenty-eght countres n our sample for the perod Secton 3 dentfes stock prce cycles and studes the relaton between fnancal lberalzaton and the tme-varyng behavor of fnancal cycles. Secton 4 examnes the dynamcs between fnancal lberalzaton and nsttutonal reforms. Secton 5 concludes. 4

6 2. The Evoluton of Global Fnancal Lberalzaton One of the most prolfc areas of emprcal research n nternatonal economcs and fnance has been the analyss of the effects of captal controls and overall fnancal lberalzaton on fnancal markets, nvestment, and growth. In spte of the great nterest of several dscplnes on the effects of deregulaton of fnancal markets, the nformaton on the evoluton of fnancal regulatons s stll fragmented. Informaton on captal account controls s mostly based on ndcators publshed by the Internatonal Monetary Fund n Exchange Arrangements and Exchange Restrctons. Ths ndcator does not dstngush between controls on captal nflows and controls on captal outflows and only dentfes two captal account regmes: a no controls regme, whch ncludes epsodes wth full lberalzaton of the captal account, and a controls regme, whch ncludes epsodes wth mnor restrctons to the free flow of captal as well as epsodes wth outrght prohbton of all captal account transactons. 2 Qunn and Inclan () and Qunn and Toyoda (2003) have mproved over the IMF classfcaton creatng an ndex that allows for dfferent ntenstes of captal account lberalzaton. Informaton on regulatons of the domestc fnancal sector s even more fragmented. There s no nsttuton complng systematc cross-country nformaton over tme and researchers have constructed ther own lberalzaton chronology. For example, Wllamson and Mahar 2 Only n 1996 dd the IMF begn to publsh a more comprehensve report on captal account controls, whch stll does not capture the ntensty of controls The new ndcators evaluate restrctons on 11 types of captal account transactons: (1) captal market securtes, (2) money market nstruments, (3) collectve nvestment securtes, (4) dervatves and other nstruments, (5) commercal credts, (6) fnancal credts, (7) guarantees, suretes, and fnancal 5

7 (1998) date lberalzaton based on the exstence of credt controls, controls on nterest rates, entry barrers to the bankng ndustry, government regulaton of the bankng sector, and mportance of government-owned banks n the fnancal system. Other efforts nclude those of Demrguc-Kunt and Detragache (1999), who date lberalzaton for ffty-three countres snce In that study, lberalzaton of the domestc fnancal sector s nterpreted as lberalzaton of domestc nterest rates. More recently, Laeven (2003) constructs an ndex of domestc fnancal sector lberalzaton for 13 developng countres coverng the perod Informaton on the lberalzaton of domestc stock markets s also stll partal. The Internatonal Fnancal Corporaton (IFC) provdes ths nformaton just for emergng markets. Agan, ths ndex only captures two regmes: a lberalzaton regme and a restrcted regme. The lberalzaton dates are determned based on whether foregners are allowed to purchase shares of lsted companes n the domestc stock exchange and whether there s free repatraton of captal and remttance of dvdends and captal gans. Bekaert and Harvey (2000) mprove over the IFC measure by also ncludng other ndcators of deregulaton of the stock market, such as the establshment of new nvestment vehcles lke country funds and depostary recepts. 3 Our chronology complements n varous ways the prevous studes on the evoluton of fnancal lberalzaton. Frst, t ncludes deregulaton epsodes n both developed and developng countres. Most prevous studes focus on emergng markets, perhaps because most concerns are assocated wth lberalzaton epsodes n those countres, wth even the most averse crtcs of backup facltes, (8) drect nvestment, (9) lqudaton of drect nvestment, (10) real estate transactons, and (11) personal captal movements. 3 There s a very large related lterature that studes the extent of de facto fnancal and economc ntegraton from observable economc varables, not from de jure government regulatons. See, for example, Bekaert et al. (2002), Frankel (2000), Obstfeld and Rogoff (2000), and Obstfeld and Taylor (2004). 6

8 captal account lberalzaton stll supportng fnancal deregulaton n mature markets. Second, our chronology deals wth the deregulaton n the captal account, the domestc fnancal sector, and stock markets. Most prevous studes have tended to focus on the elmnaton of regulatons n just one partcular fnancal sector. Ths focus on the openng of only one fnancal market may gve an ncomplete pcture of the effects of regulaton because controls n one sector can also affect the behavor of other parts of the fnancal system, whch may or may not be drectly under any type of restrctons. 4 Thrd, our database captures the ntensty of fnancal lberalzaton. Most chronologes do not tend to dstngush between dfferent ntenstes of lberalzaton/represson. 5 Snce deregulaton usually changes slowly, valuable nformaton mght be lost when the ndcators try to assess only whether or not the lberalzaton has occurred. Fnally, our database captures reversals of fnancal lberalzaton. Most prevous chronologes analyze fnancal lberalzaton epsodes as f they were permanent. Stll, many countres have undergone several lberalzaton reversals, partcularly followng currency crses. 4 Ths problem may be partcularly mportant because the complete deregulaton of fnancal systems s not accomplshed n just one round and the tme span between the deregulaton of one market and the elmnaton of controls across the board takes, n most cases, several years, as we examne below. 5 Qunn () and Qunn and Toyoda (2003) are clear exceptons. These authors construct an ndex of current account and captal account restrctons that allows for dfferent ntenstes of represson for 83 countres from 1947 to Relatve to that ndex, our measure s based on a clearly defned ndcator for each type of transacton, allowng us to compare experences of partal lberalzaton across countres and tme. For example, we classfy nternatonal borrowng by banks and corporatons as partally lberalzed when banks and corporatons are allowed to borrow abroad but subject to the followng restrctons: reserve requrements on foregn loans are between 10 and 50 percent or the requred mnmum maturty of the loan s between two and fve years. Another excepton s Edson and Warnock (2003), who measure the degree of stock market ntegraton by estmatng the avalablty of domestc equtes to foregners. 7

9 2.1 NEW MEASURES OF FINANCIAL LIBERALIZATION To construct the varous measures of fnancal lberalzaton, we use a wde range of sources, ncludng nformaton provded by both nternatonal and domestc nsttutons. The nformaton comes not only from cross-country reports but also from large number of country studes. Regardng nternatonal nsttutons, we use data from publcatons of the Bank for Internatonal Settlements, the Internatonal Fnance Corporaton, the Internatonal Monetary Fund, the Organzaton for Economc Cooperaton and Development, and the World Bank. On the domestc sde, we obtan data from annual reports of central banks, fnance mnstres, and stock exchanges of all the countres n our sample. We also use reports by The Economst s Intellgence Unt. Our new chronology ncludes nformaton on the regulatons of the captal account, the domestc bankng sector, and the stock market for the twenty-eght countres n our sample and extends from 1973 untl. 6 To capture the lberalzaton of the captal account, we evaluate the regulatons on offshore borrowng by domestc fnancal nsttutons, offshore borrowng by non-fnancal corporatons, multple exchange rate markets, and controls on captal outflows. The frst two 6 We work wth these countres because of the avalablty of rch data coverng ther processes of fnancal lberalzaton and because those countres have a relatvely long hstory of functonng stock markets. We chose a set of countres that allow us to cover dfferent regons of the world. We also chose the largest countres n each regon and the ones that have gone through perods of represson and lberalzaton, to have enough varablty n the data (the latter led us to exclude countres lke Chna and Inda). Due to the large amount of work needed n the data collecton, we lmt the number of countres. We do not nclude countres n Afrca, Central Asa, Eastern Europe, and the Mddle East for lack of long tme seres. We use the G-7 countres as a benchmark. Of course, we leave out countres that would have been nterestng to study, most notably Australa, Israel, New Zealand, South Afrca, and Turkey. But we beleve that no partcular bas was ntroduced n the selecton process. 8

10 ndcators reflect restrctons on captal nflows. Restrctons on captal nflows can take varous forms, wth the most extreme restrcton beng an outrght prohbton to borrow overseas. Mlder controls nclude restrctons of mnmum maturty on captal nflows and non-nterest reserve requrements on foregn borrowng. To measure the lberalzaton of the domestc fnancal system, we analyze the regulatons on depost nterest rates, lendng nterest rates, allocaton of credt, and foregn currency deposts. Snce monetary authortes n emergng economes often use changes n reserve requrements to control bank credt, we also collect data on reserve requrements as addtonal nformaton to evaluate the degree of restrctons mposed on the bankng sector. To set the lberalzaton dates, we focus manly on the frst two varables, the prce ndcators. However, we complement that nformaton wth the regulatons on the last three varables, those on quanttes, to have a better grasp of the degree of represson of the domestc fnancal sector. Fnally, to track the lberalzaton of stock markets, we study the evoluton of regulatons on the acquston of shares n the domestc stock market by foregners, repatraton of captal, and repatraton of nterest and dvdends. Part of these regulatons on stock market ndcators have already been documented by Bekaert and Harvey (2000) for some of the countres n our sample. For each sector, our chronology dentfes three regmes: fully lberalzed, partally lberalzed, and repressed. The crtera used to determne whether the captal account, the domestc fnancal sector, and the stock market are fully or partally lberalzed or repressed are descrbed n detal n the Appendx Table I. We establshed these crtera after collectng all the regulatons and studyng the range of restrctons mplemented n all the countres n the sample snce These crtera seem to characterze well the degrees of fnancal lberalzaton. The 9

11 chronology of restrctons compled for each country and sector and the complete lst of references used to construct t are detaled n the workng paper verson of ths paper. Table I reports the dates of partal and full fnancal lberalzaton for all the countres n the sample. For each country, the frst three columns dsplay the dates of lberalzaton of the captal account, the domestc fnancal sector, and the stock market. The last column reports dates of lberalzaton takng nto account the three sectors analyzed. A country s consdered to be fully lberalzed when at least two sectors are fully lberalzed and the thrd one s partally lberalzed. A country s classfed as partally lberalzed when at least two sectors are partally lberalzed. 2.2 PACE AND DYNAMICS OF LIBERALIZATION Fgures 1 and 2 and Table II summarze the nformaton n Table I. Fgure 1 reports separately the average lberalzaton ndex for emergng and mature economes. For each country, the lberalzaton ndex s equal to 1 when the economy s fully lberalzed, equal to 2 when the economy s partally lberalzed, and equal to 3 when the captal account, the domestc bankng sector, and the stock market are all repressed. As expected, mature economes are on average less regulated. The ndex for mature economes averages 1.5, whle for emergng economes averages 2.0. Across all regons there was a gradual lftng of restrctons, wth the ndex of lberalzaton declnng from an ntal value of 2.6 for mature markets and 2.9 for emergng economes to 1.0 and 1.2, respectvely, toward the end of the sample. As shown n ths fgure, the dynamcs of lberalzaton are dfferent across emergng and mature economes. Whle the pace of lberalzaton n mature economes s unnterrupted, reforms n emergng markets suffer a pronounced lberalzaton reversal n the early 1980s followng the debt crss and other less pronounced reversals followng the crses of the late 1990s and early 2000s. 10

12 Fgure 2 examnes separately the orderng of lberalzaton of the captal account, the domestc fnancal sector, and the stock market for both emergng and mature markets. Stock markets n developed countres were lberalzed earler, wth the ndex for ths sector oscllatng around 1.5 n the early 19s. In contrast, both the domestc fnancal sector and the captal account tended to be severely repressed untl the early 1980s. The ndexes for both sectors are on average above 2.5 for the early 19s. Fnancal markets across the board were heavly repressed n developng countres n the early 19s. But n the md and late 19s, many emergng economes lberalzed the domestc sector and the captal account. The lberalzaton reform was short-lved. Controls were re-mposed n the aftermath of the 1982 debt crss. Overall, restrctons n stock markets remaned n place untl the late 1980s, when a lberalzaton wave occurred n Asa and Latn Amerca. Table II examnes further the orderng and duraton of the lberalzaton process separately for Asa, Europe, the G-7, and Latn Amerca. The top two panels show the proporton of epsodes n whch the captal account, the domestc fnancal sector, or the stock market s lberalzed frst. The top panel focuses on partal lberalzaton epsodes; the panel below examnes full lberalzaton epsodes. The bottom two panels dsplay the duraton of lberalzaton epsodes; they report the number of months from the tme the frst market s deregulated untl lberalzaton s mplemented n all markets. The top two panels reveal that the paths toward fnancal reform dffer across regons. Bascally all the G-7 countres deregulated the stock market frst. European countres mplemented a somewhat mxed strategy toward deregulaton, wth 25 percent of the countres lberalzng the domestc fnancal sector frst and the rest deregulatng the stock market frst. On the other hand, Latn Amercan countres overwhelmngly adopted lberalzaton of the domestc fnancal sector frst, whle Asan 11

13 countres followed a mxed strategy, wth some countres optng for deregulatng the domestc sector frst and some others focusng on the stock market frst. Captal account lberalzaton n all Asan countres was mostly ntroduced at a later stage. The bottom panels n Table II show that lberalzaton reforms take a long tme to be completed. On average, 82 months elapse from the tme the frst market s lberalzed untl all markets are deregulated. The tme to completon of the lberalzaton reform was far longer n Asa than n Latn Amerca. Fnally, lberalzaton epsodes that are frst mplemented n the stock market are the ones that become completed the fastest. The varety of experences n fnancal reforms allows us to examne not only the effects of fnancal lberalzaton across all markets but also the effects of the orderng of deregulaton. 3. Stock Market Cycles and Fnancal Lberalzaton As shown above, durng the last three decades, countres around the world have lberalzed ther fnancal systems. Ths fnancal lberalzaton has been lnked to lendng booms (e.g., Gournchas et al., ). These lendng booms are not ntrnscally undesrable; they may just reflect easer access to captal markets, overall lower cost of captal, and hgher growth. Despte these potental benefts, there s a large lterature that relates fnancal lberalzaton to lendng booms, bubbles n asset prces, and crses. We brefly revew ths lterature below to show why studyng fnancal cycles s relevant to understandng the effects of fnancal lberalzaton. Whle the presence of stock market cycles s consstent wth prces reflectng fundamental values accurately and markets beng effcent, most of the theoretcal work that explans the dynamcs of lberalzaton and boom-bust cycles n fnancal markets ncorporates 12

14 some type of market mperfecton. 7 For example, Allen and Gorton (1993) develop a model where bubbles can appear f there are agency problems between nvestors and portfolo managers whle Allen et al. (1993) show that absence of common knowledge can lead to bubbles n asset prces. 8 Other papers emphasze the relaton between fnancal lberalzaton, the bankng system, boom-bust cycles, and fnancal crses. For example, Hellman et al. (2000) show that fnancal lberalzaton fuels competton and reduces bank profts, erodng banks franchse value, whle at the same tme t allows banks to take more rsk. Snce governments cannot commt not to provde balouts n case of crses, banks have ncentves to gamble for resurrecton, reapng the benefts n case of success and passng the losses to the government n tmes of crses. From a dfferent angle, Tornell and Westerman () argue that the boom-bust cycles n lendng that occur n mddle-ncome economes followng fnancal lberalzaton are generated by the nteracton of two features of these economes: asymmetrc fnancng opportuntes across nontradable and tradable sectors and systemc balout guarantees. In these countres, the mostly large frms n the tradable sector have access to world captal markets whle the smaller frms n the non-tradable sector are heavly dependent on bank credt. In ths model, the nteracton of systemc balout guarantees and credt market mperfectons can generate a boom-bust cycle phenomenon. When lberalzaton occurs, captal nflows trgger a real apprecaton that reduces 7 For models where cycles reflect fundamental values see Basu and Vnod (1994), Cecchett et al. (1990), and Lucas (1978), among others. 8 Whether t s possble to proft from cycles depends on the underlyng model. In the class of models where prces always reflect fundamental values, t s not possble to proft from stock market cycles. However, n several models wth heterogeneous agents, such as Abreu and Brunnermeer (2003) and DeLong et al. (1990), sophstcated nvestors could proft relatve to other nvestors. 13

15 the debt burden of the non-tradable sector and relaxes exstng credt constrants, leadng to more lendng, further apprecaton, fast growth n these sectors, and further relaxaton of credt constrants. Snce fnancal lberalzaton elmnates regulatory barrers that prevent agents from takng rsks, t further fuels borrowng booms and borrowng n foregn currency. When a crss occurs, the devaluaton worsens the balance sheet of the non-tradable sector and generates a recesson. Wth banks heavly exposed to the non-tradable sector, the recesson n the nontradable sector leads to a long-lastng credt crunch that s shown to outlve the recesson. Whle boom-bust fnancal cycles are mostly trggered n models wth a bankng sector and explct or mplct government guarantees (as n Krugman, 1998 and McKnnon and Pll, ), Allen and Gale (2000) show that the possblty of balouts s not necessary for asset prce bubbles to appear. They show that t s uncertanty about the future course of credt creaton n the economy and ts nteracton wth agency problems that s crucal for determnng the extent of asset prce bubbles followng fnancal lberalzaton. In ther model, nvestors use money borrowed from banks to nvest n rsky assets, whch are relatvely attractve because nvestors can avod losses n low payoff states by defaultng on ther loans. Ths rsk shftng leads nvestors to bd up the prces of rsky assets n fxed supply (such as land and equtes) above ther fundamental value, creatng a bubble. Whle bubbles can be trggered by real shocks, Allen and Gale (2000) also model bubbles beng trggered by events n the fnancal sector. In partcular, they model how fnancal lberalzaton (by fuelng an expanson of credt) generates bubbles n asset prces. In ther model, hgher prces are supported by the antcpaton of further ncreases n credt and asset prces. Naturally, a collapse n credt may precptate a crss. If the collapse of asset prces were perfectly foreseen, the bubble would not be possble n the frst 14

16 place. However, the course of fnancal lberalzaton and credt expanson s never perfectly foreseen. Thus, the uncertanty about the extent of credt expanson can fuel a bubble. The models just descrbed can explan the exstence of excessve fnancal cycles n economes wth asymmetrc nformaton, agency problems, and other dstortons n asset markets. Naturally, as argued n Tornell and Westermann (), these dstortons are more prevalent n emergng markets, suggestng that fnancal lberalzaton trggers more lendng cycles and asset prce bubbles n these economes than n mature fnancal markets. As dscussed n Secton 4, there s also a very rch lterature suggestng that fnancal lberalzaton trggers reforms and thus reduces dstortons n fnancal markets. For example, Mshkn (2003) and Stultz (1999 and ) conclude that when nvestors are not captve of domestc fnancal markets, there s pressure for governments to ntroduce reforms. They also pont out that when frms n emergng markets start lstng n stock markets n mature economes, they become more subject to accountablty and transparency, and corporate governance mproves as a result. Overall, as lberalzaton perssts, the message of ths lterature s that dstortons become less prevalent, reducng agency problems and the probablty of bubbles n asset prces. Whle the theoretcal debate about the lnk between lberalzaton and fnancal boombust patterns has advanced sgnfcantly, as evdent from the prevous dscusson, the emprcal evdence lags behnd. To test the hypotheses dscussed n the theoretcal lterature, we examne the evdence from stock markets n emergng and mature economes. The models descrbed above have specfc predctons on fnancal cycles and asset prce bubbles, thus ths s also the 15

17 focus of our paper. 9 In what follows, we descrbe the methodology used to dentfy fnancal cycles as well as ther characterstcs. 3.1 IDENTIFICATION AND CHARACTERISTICS OF FINANCIAL CYCLES There are varous technques to extract fluctuatons at busness cycle frequences. The most well known are the Hodrck-Prescott () flter, the Baxter and Kng (1995) band-pass flter, and the NBER methodology, whch s assocated wth the offcal chronology of expansons and contractons n the Unted States. In ths paper, we use the NBER methodology, whch can be replcated usng an algorthm that dentfes local maxma subject to constrants on the mnmum duraton of the cycle. Ths algorthm was frst proposed by Bry and Boschan (1971). 10 The frst step n the determnaton of cycles s the dentfcaton of cyclcal turnng ponts. The technque looks for clearly defned swngs n stock market prces n each country. We work wth the same order of duraton as busness cycles,.e., we use a two-year wndow to dentfy local maxma. We work wth ths wndow snce fnancal crses are assocated wth boom-bust cycles n fnancal markets of an ntermedate duraton. The algorthm solates local mnma and maxma n the tme seres, subject to the constrant that the duraton of each cycle 9 Another mportant strand of the emprcal lterature, for example, Grabel (1995), Kassmats (2002), and Spyrou and Kassmats (1999), examnes the effects of fnancal lberalzaton on stock market volatlty n developng countres, wth mxed conclusons. In the future t would also be mportant to study the lnks between lberalzaton, volatlty, and the ampltude of asset prce cycles. 10 Pagan and Sossounov (2003) use a smlar method to analyze cycles n the U.S. stock market. An alternatve methodology s appled by Maheu and McCurdy (2000) who use a Markov swtchng model. 16

18 cannot be less than 12 months. We do not mpose any other restrctons such as mnmum ampltude or certan duraton of cycles. 11 Naturally, the cycles we dentfy would be spurous f stock prces followed random walk processes. We thus use Monte Carlo smulatons to test that the random walk does not capture the basc propertes of our data on stock prces. The descrpton of the methodology and the tests aganst the random walk hypothess are descrbed n the workng paper verson of ths artcle. All our tests reject the random walk hypothess at all conventonal sgnfcance levels. 12 As t s common n the nternatonal fnance lterature, we look at stock prces and returns from the pont of vew of nvestors holdng assets n varous countres. Ths s why we examne stock prces n one nternatonal currency, constant (2000) U.S. dollars. (Appendx Table II reports the ndexes used and ther sources.) Fgure 3 shows the stock prces (n logs) and also dentfes the booms and crashes obtaned usng the algorthm descrbed above. The shaded areas denote expansons. We dentfy 222 cycles over tme and across countres, wth an average duraton of 42 months. Fgure 4 shows the characterstcs of the typcal cycle n Asa, Europe, the G-7, and Latn Amerca. The top panel reports the mean ampltude and duraton of booms and crashes n the 11 The algorthm dates contractons and expansons usng each country s stock prce seres, rather than the detrended seres. Therefore, busts correspond to sequences of absolute declnes n stock prces rather than perods of slow growth relatve to the trend. 12 For other evdence aganst the hypothess that stock markets follow a random, see among others Fama and French (), Frennberg and Hansson (1993), Hatgoanndes and Mesomers (), Lo and MacKnlay ( and 1999), Lunde and Tmmermann (2004), and Poterba and Summers (). 17

19 four regons, whle the bottom panel plots the typcal cycle n each regon. 13 The horzontal axs n the bottom panel shows the number of months before and after the peak of the cycle. The horzontal axs contans 25 months for expansons and 15 months for contractons. The vertcal axs reports the value of the stock ndex. To obtan the typcal cycle, the value of the stock ndex n each cycle s normalzed to 100 at the peak. Each lne n ths panel represents the average value of the stock ndex durng the 40 months around the peaks of the four regons. Cycles are more pronounced n Latn Amerca. On average, the ampltude of cycles n ths regon s about twce as large as the ampltude of cycles n the G-7 countres. As expected, the most developed countres, the G-7, have mlder stock market cycles, wth the Asan and the other European stock market cycles beng of ntermedate magntudes. To examne the effects of fnancal lberalzaton on fnancal cycles, we compare the characterstcs of fnancal cycles n the short and long run followng the deregulaton of fnancal markets. Our frst approach s n the event study tradton, analyzng the behavor of stock markets n the aftermath of lberalzaton relatve to ther functonng n represson tmes, those years before deregulaton occurs. We then report regresson results that control for other factors and also examne whether the orderng of the lberalzaton matters. 3.2 EVENT STUDIES Fgure 5 examnes the characterstcs of fnancal cycles around the partal lberalzaton of fnancal markets, that s, when at least two sectors are partally lberalzed. We classfy 13 In all fgures and tables, the depth of the contracton s measured as the change between the peak and the followng trough, as a percent of the md value of the peak and trough. Smlarly, the heght of an expanson s measured usng the change between the trough and the followng peak, as a percent of the md value of the trough and the followng peak. Ths measure makes the ampltude of expansons and contractons comparable. 18

20 fnancal cycles n three categores, those that occur durng represson tmes, those that occur n the short run after lberalzaton, and those that occur n the long run followng lberalzaton. The short run s defned as the perod of four years after lberalzaton. The long run ncludes the ffth year after lberalzaton and the years thereafter, condtonal on the deregulaton not beng reversed. 14 The top panel n Fgure 5 shows the average ampltude of booms and crashes for all countres n our sample durng represson tmes (the strped bars), n the short run followng lberalzaton (the whte bars), and n the long run after lberalzaton (the gray bars). It also reports the characterstcs of cycles separately for emergng and mature markets to account for possble heterogenety n the evdence. The bottom panel examnes whether the dfferences of ampltudes across regmes are statstcally sgnfcant. The evdence for the twenty-eght countres n the sample ndcates that the ampltude of booms substantally ncreases n the mmedate aftermath of lberalzaton (about 25 percent hgher than durng represson tmes). But equty markets stablze n the long run f lberalzaton perssts, wth the ampltude of booms about 20 percent smaller than n represson tmes. Smlarly, the ampltude of crashes ncreases n the mmedate aftermath of lberalzaton (about 13 percent hgher than durng represson tmes), but declnes to about 80 percent of ts sze durng represson tmes f lberalzaton perssts n the long run. As shown n the bottom panel, bascally all these dfferences are statstcally sgnfcant at conventonal levels. The evdence for the twenty-eght countres, however, obscures mportant dfferences across emergng and mature markets. The short-run effects of lberalzaton n emergng markets are very pronounced, wth booms and crashes n the mmedate aftermath of lberalzaton 14 Snce the choce of the short-run wndow s ad-hoc, we also examne the robustness of the results to dfferent defntons of wndow sze. The results for three- and sx-year wndows are qute smlar. 19

21 ncreasng by about 35 percent over ther sze durng represson. Stll, f lberalzaton perssts, fnancal cycles become less pronounced, wth booms about 20 percent smaller than durng represson tmes and crashes declnng to pre-lberalzaton levels. 15 On the other hand, the evdence from mature markets ndcates that lberalzaton does not trgger more volatle stock markets n the short run, wth booms ncreasng very lttle and crashes becomng less pronounced even n the short run. Furthermore, lberalzaton also generates more stable fnancal markets n mature economes n the long run too, wth crashes averagng only about percent of ther sze n represson tmes. 3.3 ACCOUNTING FOR DOMESTIC AND EXTERNAL SHOCKS Whle the evdence n Fgure 5 suggests that fnancal lberalzaton nfluences the sze of expansons and contractons n fnancal markets, stock prce fluctuatons also reflect changes n other market fundamentals. For example, stock prces respond to expansons and recessons n the domestc economy. They also react to world economc condtons. 16 The omsson of these varables may bas our results, especally snce the tmng of lberalzaton may also be affected by these factors. In fact, Latn Amercan countres rentroduced controls on domestc nterest rates and credt and re-mposed controls on captal flows followng the hkes n nterest rates n ndustral countres n the early 1980s. Also, many emergng markets lberalzed ther fnancal markets n tmes of abundance of nternatonal captal flows, as n the early 1990s. Insofar as 15 The epsode of long-run lberalzaton ncludes the crashes durng the global collapse of stock market n If we exclude those stock market crashes, the ampltude of the downturns n emergng markets declnes to about 93 percent of the ampltude of crashes durng represson tmes. 16 For example, Calvo et al. (1993) argue that decreases n U.S. nterest rates trgger large captal flows to emergng markets, whch n turn fuel ncreases n asset prces. 20

22 countres react to bad tmes by adoptng captal controls and to good tmes by relaxng them, there s a danger that we may ascrbe the ncrease n the sze of booms to lberalzaton and the amplfcaton of crashes to captal controls, when n fact stock prces are just respondng to changes n world market condtons. To account for domestc and external factors, the event study analyss s complemented wth regressons that control for growth n domestc and world economc actvty and changes n world real nterest rates. We estmate the followng equaton by least squares wth heteroskedastc-consstent standard errors, ampltude r sr = 'Χ + 1d + β1d + 1 α ρ λ d + ε, (1) lr where ampltude s the ampltude of expanson (contracton) ; Χ s a matrx of control varables that ncludes an external factors ndex and the change n domestc output durng each expanson (contracton), d r s a dummy varable equal to one f the cycle occurs durng represson tmes and zero otherwse, sr d s a short-run lberalzaton dummy varable equal to one f the cycle occurs n the mmedate aftermath of fnancal lberalzaton (four-year wndow) and zero otherwse, lr d s a long-run lberalzaton dummy varable equal to one f the cycle occurs after four years have elapsed from the tme of fnancal lberalzaton and zero otherwse. In the sprt of the currency crss emprcal lterature, we capture world market condtons by usng a composte ndex of world output and nterest rates. The ndex s the weghted average of world output growth and the declne n the world average real nterest rate, wth the weghts on world output and nterest rates nversely related to the volatlty of the seres. Snce world output enters wth a postve sgn and the nterest rate wth a negatve sgn, an ncrease n ths ndex reflects better global economc condtons and s expected to fuel larger 21

23 booms and smaller crashes. The world average real nterest rate s the average of the U.S. federal funds real nterest rate, and Japan s and the Unted Kngdom s real money market rates. World output s captured by the evoluton of ndustral producton n the G-3 countres. Fnally, domestc output s captured by the ndex of ndustral producton n the domestc economy. All data come from the Internatonal Fnancal Statstcs publshed by the Internatonal Monetary Fund. Table III shows the estmaton results. As n Fgure 5, the table examnes the effects of overall partal fnancal lberalzaton (when at least two sectors have been partally lberalzed). As expected, an mprovement n world market condtons leads to larger booms and smaller crashes. For example, a one-standard devaton ncrease n the external factors ndex results n a 10 (11) percentage pont ncrease n the average ampltude of stock market expansons (crashes) across all countres n the sample. 17 Smlarly, booms and crashes n stock markets are also related to upturns and recessons n the domestc economy. Even after accountng for these other determnants of fluctuatons n stock prces, fnancal lberalzaton stll matters. Fnancal lberalzaton s followed by larger cycles n the short run, whle markets stablze n the long run. For example, n the mmedate aftermath of lberalzaton, booms ncrease by about 35 percent n emergng markets and by 20 percent n mature markets relatve to represson tmes. Smlarly, crashes n emergng markets ncrease by percent n the mmedate aftermath of lberalzaton vs-à-vs represson tmes. Note that the results n Table III suggest two dfferent patterns n the aftermath of lberalzaton. Whle larger booms follow lberalzaton n both emergng and mature markets, t 17 Ths shock s comparable to a three percentage pont decrease of the world average real nterest rate or a nne percent growth n the world output durng the lfe of the partcular phase of the stock market cycle. 22

24 s only n emergng markets that crashes are more severe followng lberalzaton. The average short-run experence n emergng markets seems to support the evdence from the crss lterature that concludes that lberalzaton s assocated wth excessve fnancal booms and crashes. Lberalzaton epsodes do not seem to brng (on average) ths short-run pan to mature markets. In those economes, larger booms are not followed by larger crashes, suggestng that larger booms may just reflect the reducton n the cost of captal once deregulaton takes place, as the neoclasscal theory ndcates. 18 Stll, n the long run, fnancal lberalzaton s related to more stable fnancal markets n both emergng and mature market economes. 3.4 ORDERING OF LIBERALIZATION In ths secton, we examne whether the order of deregulaton matters. To do so, we estmate the followng regresson, ampltude = α' X + ρ d + β d + β d + β d + λ d + ε. (2) 1 r 1 sr 2 CA 3 SM 1 lr,2 The varables CA d and SM d capture the possble dfferental effects on booms and crashes from openng respectvely the captal account or the stock market frst. These dummy varables are equal to one f the cycle occurs when that partcular sector s lberalzed frst, and zero otherwse. Thus, the average ampltude of booms (crashes) n the short run followng lberalzaton s captured by β 1 f lberalzaton starts wth the deregulaton of the domestc bankng ndustry, by β 1 + β 2 f t starts wth the openng of the captal account, and by 1 β 3 β + f t starts wth the deregulaton of the stock market. 18 As always, averages may hde exceptons. Denmark, Fnland, Norway, and Sweden suffered fnancal collapses and bankng crses n the early 1990s followng lberalzaton. 23

25 Table IV shows that n general the orderng of lberalzaton does not matter. Openng the captal account or the stock market frst does not have a dfferent effect than openng the domestc fnancal sector frst. There s only one excepton: The ampltude of crashes almost doubles n emergng markets (compared to ther sze durng represson) f the captal account s opened up frst. Ths fndng provdes some support to the vew that the lberalzaton of the captal account may trgger rsky assets to be prced further away from ther fundamental value, perhaps due to problems n nternatonal captal markets. Ths result mght provde some mld support to the usual clam that the captal account should be opened last. 4. The Sequencng of Fnancal Lberalzaton and Insttutonal Reform The strong lnks between fnancal lberalzaton and crses n emergng markets have prompted an ntense debate among academcs and practtoners about the benefts of fnancal deregulaton and ts optmal sequencng. For example, Rodrk (1998) and Stgltz (2000) clam that unfettered captal flows are dsruptve to fnancal stablty and growth, questonng the benefts of fnancal globalzaton and supportng calls for captal controls. Overall, there s consensus that at the core of the lnk between crses and lberalzaton s the lack of good publc and corporate governance and the exstence of weak government polces and nsttutons. The argument goes then to ndcate that governments should sequence reforms, frst mprovng government nsttutons and better regulatng domestc fnancal nsttutons and only then deregulatng the fnancal ndustry and openng the captal account. In fact, Calvo (1998) and Fscher (1998) argue that weaknesses n the domestc fnancal sector before fnancal lberalzaton are mportant n determnng the rsks assocated wth fnancal lberalzaton. Prasad et al. (2003) add emprcal support to the dea that good nsttutons, governance, and 24

26 macroeconomc fundamentals pror to fnancal lberalzaton are crucal to reapng ts potental benefts. Stll, the argument that lberalzaton should be preceded by nsttutonal reforms may be rrelevant f the tmng s such that reforms never predate lberalzaton, wth nsttutonal mprovements happenng mostly as a result of fnancal deregulaton. In other words, governments may have few ncentves to promote reforms n countres wth repressed fnancal sectors. For example, Rajan and Zngales (2003a, b) argue that well-establshed frms (and therefore publc offcals) may n general oppose reforms that promote fnancal development because t breeds competton. These frms can even be hurt by fnancal development and lberalzaton as they mply better dsclosure rules and enforcement (reducng the mportance of these frms collateral and reputaton) and permt newcomers to enter and compete away profts. However, opposton to reforms may be weaker n more open economes wth abundant trade and cross-border flows. In ths case, free access to nternatonal captal markets allows the largest and best-known domestc frms to tap foregn markets for funds, wth ther support for the polces that favor fnancal development and lberalzaton becomng stronger. Once fnancal lberalzaton occurs, t can have a postve mpact on domestc nsttutons. For example, Alessandra and Qan () develop a general equlbrum model that endogenzes the effcency of fnancal ntermedares after fnancal lberalzaton and show that removng restrctons on nternatonal captal flows may change the effcency of ntermedares. Smlarly, Gournchas and Jeanne () present a model n whch nternatonal captal moblty can enhance the ncentves to reform n two ways: () captal nflows ncrease the benefts of reform by expandng the domestc captal base and () the threat of captal flght may dssuade the domestc government from devatng from good polces. Also, Stulz () shows that 25

27 nternatonal fnancal ntegraton can mprove the functonng of the domestc fnancal sector by allevatng the twn agency problems, that s the ncentve of governments and corporate nsders to exproprate outsde nvestors. To shed some new lght on ths debate, we compare the tmng of fnancal lberalzaton and nsttutonal reforms. 19 To do so, we collect data on the qualty of nsttutons as well as on the laws governng the proper functonng of fnancal systems. The nformaton on the qualty of nsttutons s captured by the ndex of law and order. Ths ndex s publshed n the Internatonal Country Rsk Gude (ICRG). The law sub-ndex assesses the strength and mpartalty of the legal system, whle the order sub-ndex assesses the popular observance of the law. Each ndex can take values from one to three, wth lower scores for less tradton for law and order. To better assess the functonng of the fnancal system, we use nformaton on the exstence and enforcement of nsder tradng laws constructed by Bhattacharya and Daouk (2002). Appendx Table III reports the tme of mprovement n the ndex of law and order as well as the tme n whch the nsder tradng law s passed and the tme n whch nsder tradng starts to be prosecuted. We defne an mprovement n the qualty of government nsttutons when the ndex of law and order ncreases by one unt and ths change s at least mantaned for two years. The top panel n Table V examnes the sequencng of lberalzaton and reform n our sample of twenty-eght countres. It shows the probabltes that fnancal lberalzaton occurs condtonal on reforms havng already been mplemented. In partcular, we look at whether reforms to nsttutons occur pror to the partal or full lberalzaton of the fnancal sector. If governments mprove the qualty of nsttutons pror to start deregulatng the fnancal sector, 19 Chnn and Ito () and Tornell et al. (2003) study the relaton between captal account lberalzaton and trade lberalzaton and fnd that the latter precedes the former. 26