The Positive Link between Financial Liberalization, Growth and Crises

59 Pages Posted: 13 Apr 2004

See all articles by Aaron Tornell

Aaron Tornell

University of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute)

Frank Westermann

University of Osnabrueck - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); CESifo (Center for Economic Studies and Ifo Institute) - Ifo Institute

Lorenza Martinez Trigueros

Bank of Mexico

Multiple version iconThere are 2 versions of this paper

Date Written: March 2004

Abstract

There is no agreement regarding the growth-enhancing effects of financial liberalization, mainly because it is associated with risky international bank flows, lending booms, and crises. In this paper we make the case for liberalization despite the occurrence of crises. We show that in developing countries trade liberalization has typically been followed by financial liberalization, which has indeed led to financial fragility and a greater incidence of crises. However, financial liberalization also has led to higher GDP growth. In fact, the fastestgrowing countries are typically those that have experienced boom-bust cycles. That is, there is a positive link between GDP growth and the bumpiness of credit, which is captured by the negative skewness - not by the variance - of credit growth. To substantiate our interpretation of the data we present a model that shows why in countries with severe credit market imperfections, liberalization leads to higher growth and, as a byproduct, to financial fragility. Thus, occasional crises need not forestall growth and may even be a necessary component of a developing country's growth experience. Finally, our analysis indicates that foreign direct investment does not obviate the need for risky international bank flows, as the latter are the only source of financing for most firms in the nontradables sector.

JEL Classification: E20, E44, F30, F43, G15, O40, O50

Suggested Citation

Tornell, Aaron and Westermann, Frank and Martinez Trigueros, Lorenza, The Positive Link between Financial Liberalization, Growth and Crises (March 2004). CESifo Working Paper Series No. 1164, Available at SSRN: https://ssrn.com/abstract=528225

Aaron Tornell

University of California, Los Angeles (UCLA) - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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CESifo (Center for Economic Studies and Ifo Institute)

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Frank Westermann (Contact Author)

University of Osnabrueck - Department of Economics ( email )

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Osnabrueck, D-49069
Germany

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

CESifo (Center for Economic Studies and Ifo Institute) - Ifo Institute ( email )

Poschinger Str. 5
Munich, 01069
Germany

Lorenza Martinez Trigueros

Bank of Mexico ( email )

Av. 5 de Mayo 18
Piso 4
Col. Centro 06059, 06059
Mexico

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