Financial

liberalization

Alberto, Chavez, Chua

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

-Kaminsky & Schmukler (2008)

Introduction
Financial Liberalization
Deregulation of financial markets

ADVANTAGES DISADVANTAGES
● Allows capital to move to ● Leads to banking crises
its most attractive ○ Banks’ risky behavior
destination is triggered
● Fosters better ● Triggers short-run
functioning of financial financial booms and busts
markets
● Triggers an increase in
investment rates
Data
◎ Main aspects of liberalization: ◎ 28 countries
○ Liberalization of banking ○ G-7 countries
industry (63 episodes) ○ Asian region
○ Opening up of the capital ○ European region
account (67 episodes) ○ Latin American
○ Liberalization of ◎ 1973-2005
domestic stock market
(49 episodes)
Methodology

◎ The characteristics of stock prices cycles over time set the

groundwork for examining the effects of financial
liberalization.
◎ Compare behavior of financial cycles
○ Repression
○ Aftermath of financial liberalization
○ Long-run following liberalization
Results

EMERGING MARKETS MATURE MARKETS

◎ Short run: substantially ◎ Leads to an increase in the
more pronounced booms value of firms, but not to
and crashes larger crashes
◎ Long run: financial cycles
are less pronounced
◎ Government reforms mostly
occur after financial
liberalization
1.
Evolution of Global
Financial Liberalization
Capital Accounts

◎ Mostly based on indicators published by the IMF in Exchange

Arrangements and Exchange Restrictions
○ “Controls” regime vs “no controls” regime
○ No distinction between controls on capital inflows and
controls on capital outflows
◎ Quinn and Inclan (1997) and Quinn and Toyoda (2003) created an
index that identifies different intensities of capital account
liberalization
Domestic Financial Sector

◎ Researchers have constructed their own liberalization

chronology
○ Williamson and Mahar (1998): existence of credit controls,
controls on interest rates, entry barriers to banking industry,
government regulation on banking sector, and importance of
government-owned banks in the financial system
○ Demirguc-Kunt and Detragiache (1999): liberalization of
domestic interest rates
○ Laeven (2003): index of domestic financial sector
liberalization
Domestic Stock Markets

◎ International Financial Corporation (IFC) provides this

information just for emerging markets
○ “Liberalization” regime vs “restricted” regime
◎ Bekaert and Harvey (2000) included other indicators of
deregulation of the stock market
○ Establishment of new investment vehicles
◉ Country funds
◉ Depositary receipts
KAMINSKY & SCHMUKLER (2008)
◎ Developing and developed
countries
◎ Capital account, domestic
financial sector, and stock
markets
◎ Intensity of financial
liberalization
◎ Reversal of financial
liberalization
PREVIOUS STUDIES
◎ Emerging markets
◎ One particular financial sector
only
◎ Occurrence of liberalization
◎ Permanent financial
liberalization
New measures of Financial Liberalization

INTERNATIONAL DOMESTIC
◎ Bank for International ◎ Annual reports of central
Settlements banks
◎ International Finance ◎ Finance ministries
Corporation ◎ Stock exchanges
◎ IMF
◎ Organization for Economic
Cooperation and
Development
◎ World Bank
Liberalization of Capital Accounts
◎ Evaluate the regulations on offshore borrowing by domestic
financial institutions and offshore borrowing by nonfinancial
corporations, multiple exchange rate markets, and controls on
capital outflows

Liberalization of the Domestic Financial System

◎ Analyze regulations on deposit interest rates, lending interest
rates, allocation of credit, foreign currency deposits, and reserve
requirements
Liberalization of the Domestic Stock Market

◎ Study the evolutions on the acquisition of shares in the domestic

stock market by foreigners, repatriation of capital, and
repatriation of interest and dividends
Fully Liberalized
(FL): at least 2 sectors
are fully liberalized
and the third one is
partially liberalized

Partially Liberalized
(PL): at least 2 sectors
are partially
liberalized

Restricted
Pace and Dynamics of Liberalization
Pace and Dynamics of Liberalization

Stock Market
Pace and Dynamics of Liberalization

Capital Account

Domestic Financial
Sector
Pace and Dynamics of Liberalization

Proportion of
episodes in which
the capital account,
the domestic
financial sector, or
the stock market is
liberalized first
Pace and Dynamics of Liberalization

Number of months
from the time the
first market is
deregulated until
the liberalization is
implemented in all
markets
2. Stock Market
Cycle and
Financial
Liberalization
 “
There is a large literature that relates
financial liberalization to lending
booms, bubbles in asset prices and
crises. Studying financial cycles is also
relevant to understanding the effects of
financial liberalization.
 Stock Market Cycles and Financial Liberalization
◎ Allen and Gorton (1993) developed a model where bubbles can appear if
there are agency problems between investors and portfolio managers.
○ The absence of common knowledge can lead to bubbles in asset prices.

◎ Hellman et al. (2000) show that financial liberalization fuels competition

and reduces bank profits, eroding banks’ franchise value, while at the
same time it allows banks to take more risk.
○ Banks have incentives to gamble for resurrection, reaping the benefits in
case of success and passing the losses to the government in times of crises,
because government will provide bailouts.
 Stock Market Cycles and Financial Liberalization
◎ Tornell and Westerman (2005) argue that the boom-bust cycles in lending that
occur in middle-income economies following financial liberalization are
generated by the interaction of two features of these economies:
○ Asymmetric financing opportunities across non-tradeable and tradeable sectors
○ Systemic bailout guarantees
○ When liberalization occurs, capital inflows trigger a real appreciation that reduces the
debt burden of the non-tradeable sector and relaxes existing credit constraints,
leading to more lending, further appreciation and relaxes existing credit constraints.
○ Since regulatory barriers that prevent agents from taking risks are eliminated,
borrowing booms and borrowing in foreign currency are fueled.
 Stock Market Cycles and Financial Liberalization
◎ Allen and Gale (2000) show that the possibility of bailouts is not necessary for
asset price bubbles to appear.
● It is uncertainty about the future course of credit creation in the economy and its
interaction with agency problems that is crucial for determining the extent of asset
price bubbles following financial liberalization.
● Financial liberalization (by fueling an expansion of credit) generates bubbles in asset
prices.

◎ The paper examines the evidence from stock markets in emerging and mature economies
 Steps in the determination of cycles

3rd Step
Stock prices and returns
1st Step are examined from the
Identification of cyclical point of view of investors
turning points (looks for 4th Step
holding assets in various
clearly defined swings in 2nd Step Characteristics of
counties (examined
stock market prices in Monte Carlo simulations financial cycles in the
stock prices in one
each country) were used to test that short and long run
international currency)
the random walk does following the deregulation
not capture the basic of financial markets were
properties of the data on compared to examine the
stock prices. effects of financial
liberalization on financial
cycles.
 1st Step NBER (National Bureau of Economic Research)
Identification of cyclical
turning points (looks for Methodology
clearly defined swings in
stock market prices in
each country)
◎ Associated with the chronology of expansions and contractions
in the United States.
◎ The paper replicated the NBER methodology using an algorithm
that identifies local maxima subject to constraints on the
minimum duration of the cycle.
◎ Algorithm isolates local minima and maxima in the time series
subject to the constraint that the duration of each cycle cannot
be less than 12 months.
 Monte Carlo simulations

2nd Step ◎ All the tests reject the random walk hypothesis at all
Monte Carlo simulations
were used to test that
the random walk does
not capture the basic
properties of the data on
stock prices.
conventional significance levels.
○ Random walks processes - stock price changes have
the same distribution and are independent of each
other, so past movements or trends cannot be used to
predict its future movement.
○ In other words, prices take a random and
unpredictable path.
 3rd Step
Stock prices and returns
are examined from the
point of view of investors
holding assets in various
counties (examined
stock prices in one Figure 3: shows stock prices (in logs) and also identifies the booms and
international currency) crashes obtained using the algorithm in the first step
● Shaded area denotes expansion
● 222 cycles over time and across countries, with an average
duration of 42 months
 3rd Step
Stock prices and returns
are examined from the
point of view of investors
holding assets in various
counties (examined
stock prices in one Figure 4: Characteristics of the typical cycle in Asia, Europe, G-7 and
international currency) Latin America
● Mean amplitude and duration of booms and crashes
 3rd Step
Stock prices and returns
are examined from the
point of view of investors
holding assets in various
counties (examined
stock prices in one
international currency)
Figure 4: Characteristics of the typical cycle in Asia, Europe, G-7 and
Latin America
● Plot of the typical cycle in each region
● Horizontal axis: number of months before and after the peak of the cycle
● Vertical axis: value of the stock index (normalized to 100 at the peak)
 Examination of the effects of financial
liberalization on financial cycles

◎ Comparing the characteristic of financial

cycles in the short and long run following
the deregulation of financial markets.
○ Event Studies
○ Accounting for domestic and
4th Step
Characteristics of external shocks
financial cycles in the
short and long run ○ Ordering of Liberalization
following the deregulation
of financial markets were
compared to examine the
effects of financial
liberalization on financial
cycles.
Event Studies

● Analyzing the behaviour of stock markets in the aftermath of

liberalization relative to their functioning in repression times, those
years before deregulation occurs.
● Examines the characteristics of financial cycles around the partial
liberalization of financial markets when at least two sectors are partially
liberalized
● Financial cycles are classified into three categories:
a. Occur during repression times
b. Occur in the short run after liberalization (period of four years after
liberalization)
c. Occur in the long run following liberalization (includes the fifth year after
liberalization and the years thereafter conditional on the deregulation not
being reversed)
●
Event Studies

Figure 5: Average amplitude of

booms and crashes
● Repression times (striped
bars)
● Short run (white bars)
● Long run (gray bars)

Bottom panel: level of

significance for differences of
amplitudes across regimes
Event Studies

● Amplitude of booms substantially increases in the immediate aftermath

of liberalization (25% higher than during repression times)
● Equity markets stabilize in the long run if liberalization persits (20%
smaller than in repression times)
● Amplitude of crashes increases in the immediate aftermath of
liberalization (about 13% higher than during repression times)
● Amplitude of crashes declines to about 80% of its size during repression
times if liberalization persists in the long run.
Accounting for Domestic and External Shocks
● Stock price fluctuations also reflect changes in other market
fundamentals
● Event study is completed with regressions that control for growth in
domestic and world economic activity and changes in world real interest
rates.
● Estimated by least squares with heteroskedastic-consistent standard
errors

Where amplitude = amplitude of expansion (contraction)

Xi = matrix of control variables that includes an external factors index and change in domestic
output during each expansion (contraction)
dir = dummy (1= if cycle occurs during repression)
disr = dummy (1= if cycle occurs in the immediate aftermath of financial liberalization)
dilr = dummy (1= if cycle occurs after four years have elapsed from the time of financial
liberalization)
Accounting for Domestic and External Shocks

Estimation Results
- Suggests two different patterns
- For emerging, crashes are more
severe following liberalization;
supports previous literature that
liberalization is associated with
excessive financial booms and
crashes
- For mature, larger booms are not
followed by larger crashes,
suggesting that larger booms may
reflect the reduction in the cost of
capital once deregulation takes
place
- In the long run, financial markets
appear to be more stable in both
emerging and mature economies
 Ordering of Liberalization
● Examine whether the order of deregulation matters

Where amplitude = amplitude of expansion (contraction)

Xi = matrix of control variables that includes an external factors index and change in domestic output during each
expansion (contraction)
dir = dummy (1= if cycle occurs during repression)
disr = dummy (1= if cycle occurs in the immediate aftermath of financial liberalization)
dilr = dummy (1= if cycle occurs after four years have elapsed from the time of financial liberalization)
diCA and diSM = capture the possible differential effects on booms and crashes from opening respectively the capital
account or the stock market first (1=cycle occurs when that particular sector is liberalized)
B1 = captures average amplitude of booms in the short run following liberalization if liberalization starts with the
deregulation of the domestic banking industry
B1 + B2 = if it starts with the opening of the capital account
B1 + B3 = if it starts with the deregulation of the stock market
Ordering of Liberalization

● In general, the ordering of liberalization does not matter

● Amplitude of crashes almost doubles in emerging markets (compared to their size during repression) if
the capital account is opened up first
● Supports the view that the liberalization of the capital account may trigger risky assets to be priced
further away from their fundamental value (perhaps due to problems in international markets)
● Mild support to the usual claim that the capital account should be opened last.
3.
Sequencing of Financial
Liberalization and
Institutional Reform
Financial Liberalization & Crises in Emerging Market
prompted debates about deregulation and its optimal sequencing

Rodrik (1998) and Stiglitz (2000)

unfettered capital flows are disruptive to financial stability and growth,
questioning the benefits of financial globalization and supporting calls
for capital controls.

Calvo (1998) and Fischer (1998)

weaknesses in the domestic financial sector before
financial liberalization are important in determining
the risks
Financial Liberalization & Crises in Emerging Market
prompted debates about deregulation and its optimal sequencing

Prasad et al. (2003)

empirical support to the idea that good institutions, governance, and
macroeconomic fundamentals prior to financial liberalization are crucial
to reaping its potential benefits.
Overall consensus
Lack of good public and corporate governance
Weak government policies and institutions
Government should sequence reforms
However...

Reforms never predate liberalization

With institutional improvements usually happens as a result of
deregulation

Rajan and Zingales (2003) argue that well-established firms (& public
officials) may oppose reforms that promote financial development
because it breeds competition, with better disclosure rules and
enforcement

Nonetheless, open economies tend to support reforms to tap foreign

markets for funds.
Positive Impacts on Domestic Institutions
Removing restrictions on international capital flow/mobility

ADVANTAGES
● May change the efficiency of intermediaries
● Expanding domestic capital base
● Capital flight prevents bad policies
● Alleviating “twin agency problem” or government
and corporate expropriate outside investors
 Comparing the Timing of Liberalization and Reforms

Index of Law
& Order
Collect data increases by
on quality 1 unit
and laws on
systems
“Index on Law Insider
and Order” by
International Trading
Country Risk Laws
Guide (ICRG)
➢ 28 countries
➢ Shows probabilities that
financial liberalization
occurs conditional on
reforms have already
been implemented
➢ Prob of partial
liberalization (->1) if
governments improve
institutions prior to
deregulation
➢ ->0 if liberalization
triggers reforms
➢ Dynamics between
emerging and mature
economies differ
➢ Emerging: reforms such as
protection of property
rights and insider trading
occur after liberalization
➢ Mature: property rights
protection are in place
➢ Does not improve those
lacking in good property
right or prosecution of
insider trading
As it predates improvements in institutions in emerging markets...

May trigger excessive booms and busts in short run due to

variety of distortions

...but triggers reforms with capital market becoming more

stable in the long run

Developed economies:
distortions are less pervasive due to reforms precede
deregulations
amplitudei= α’Xi+ρ1dir+β1dirs +λ1dilr+τ1diL&O+τ2dilTA+τ2dilTE+εi

To capture the effects of changes in institutions

on financial booms and busts, we estimate the
following regression
amplitudei= α’Xi+ρ1dir+β1dirs +λ1dilr+τ1diL&O+τ2dilTA+τ2dilTE+εi

➢ also evaluates the possible effects of changes in government

institutions
➢ diL&Ois a dummy variable equal to i one if the boom (crash) occurs
when the “law and order” index has improved or is at its highest level
and zero
➢ dilTAis a dummy variable equal to one if the boom (crash) occurs
following the approval of the “law prosecuting insider trading” and
zero otherwise
➢ dilTEis a dummy variable equal to one if the boom (crash) occurs when
“insider trading prosecution is enforced” and zero otherwise.
17%
Booms declining with improvement in law and order

5%
Crashes declines too (explains mature markets)

0%
Insider Trading Laws impact on financial cycles
Conclusions
Conclusions
Empirical Evidence
On time-varying relation
between liberalization,
government institutions, and
market Not Robust
1970s
Liberalization proceeds
smoothly in mature countries
but reverses on average
developing economies
Emerging Markets Mature Markets
Liberalization fuels Reversals in order or
instability in the short run chronologies compared
(agency problem) while to emerging markets
market stabilizes in long run
1900s Question:
Financial sector did not Can countries deregulate
improve monotonically over financial systems without
time in mature economies. becoming vulnerable to
Why did the dynamics crises since costs are large?
changed?
Thank You!