Rethinking the E ects of Financial Liberalization

Transcription

1 Rethinking the E ects of Financial Liberalization Fernando Broner and Jaume Ventura CREI and Universitat Pompeu Fabra August 2007

2 What are the e ects of nancial liberalization? We focus on consumption, investment, growth, and welfare Conventional view is that consumption stabilizes, investment and growth increase, and welfare improves But we know that in some countries nancial liberalization has led to increase in consumption volatility current account surpluses reduction in investment and growth Why does this happen? What are the welfare implications?

3 A model of asset trade with endogenous enforcement Two periods, Today and Tomorrow (with state s 2 S occurring with prob s ) Consider a country with many individuals, i 2 I, that maximize u(c i0 ) + s u(c is ) subject to (c i0 y i0 ) + s2s c is y is s2s s (c is y is ) R s = 0 if s =2 E FOC s are given by u 0 (c is ) = 8 < : u 0 (c i0 ) R s u 0 (y is ) if s 2 U i if s =2 U i U i = fs 2 S : s 2 E or u 0 (c i0 ) R s u 0 (y is )g where U i are states for which borrowing constraint does not bind for i From now on we assume u() = () What determines enforcement? With strong institutions, E = S With weak institutions, E results from maximizing ex-post average utility in each state

4 Autarky equilibrium Prices clear domestic markets R s = ( y s y 0 if s 2 E 0 if s =2 E Then U i = E and equilibrium consumption is c i0 = i y 0 and c is = ( i y s if s 2 E y is if s =2 E where i is the relative wealth of i i = y i0 + y 0 + s2e s y is y s s s2e If the country has weak institutions any proposed E must satisfy c is y is 0 for all s 2 E

5 Trade equilibrium Rest-of-world has good institutions (E = S) and is large Prices clear world markets Then U i s 2 S : s 2 E or y is y s R s = R s = y s i c i0 = i y 0 and c is = y 0 for all s 2 S and equilibrium consumption is ( i y s if s 2 U i y is if s =2 U i where i is the relative wealth of i i = y i0 y 0 + s y is s2u i y s + s2u i s If the country has weak institutions any proposed E must satisfy c is (y is + x is) 0 for all s 2 E

6 The experiment Financial liberalization is a move from autarky to trade Before trade liberalization prices are R s = ( y s y 0 if s 2 E 0 if s =2 E Rest-of-world has strong institutions (E = S), at endowments (y s = y 0 for all s 2 S), and is large After trade liberalization prices are R s = R s = for all s 2 S interest rate equal to (inverse of) time preference insurance at actuarially fair prices Consider a country with high but uncertain growth potential ys s s2s y 0 To simplify, we assume S = fg; Bg with G = B = 2

7 Financial liberalization with strong institutions: the conventional view Before liberalization, individual and aggregate consumption move one-to-one c i0 = i y 0, c ib = i y B, and c ig = i y G c 0 = y 0, c B = y B, and c G = y G where i is the relative wealth of i i = + yi0 + y 0 2 yib + y ig y B y G After liberalization, individual and aggregate consumption are both at c i0 = c ib = c ig = + c 0 = c B = c G = + y i0 + 2 (y ib + y ig ) y (y B + y G ) Financial markets allow countries to smooth consumption over time and across states of nature

8 Financial liberalization revisited: the case of weak institutions Example #: Why do high-growing countries run current account surpluses? (Borrowing and lending model) Assume y ib = y ig = y i, y > y 0, and = Assume E A = E T =? Before liberalization, there is both individual and country autarky c i0 = y i0 and c i = y i After liberalization, we have instead that 8 < c i0 = : where I U = fi 2 I jy i y i0 g c 0 = y 0 and c = y 2 (y i0 + y i ) if i 2 I U y i0 if i =2 I U and c i = 8 < : 2 (y i0 + y i ) if i 2 I U y i if i =2 I U c 0 = y 0 2 (y i0 y i ) and c = y + U 2 (y i0 y i ) U Liberalization leads to CA surplus and steeper aggregate consumption Welfare increases: I I U are not a ected, I U are better o and lend now

9 Financial liberalization revisited: the case of weak institutions Example #: Why do high-growing countries run current account surpluses? How does nancial liberalization a ect enforcement? Before liberalization, there is enforcement if i A yi y 0 After liberalization, there is enforcement if i T yi y y 2 (y 0 + y ) (> 0) Unless terms-of-trade e ects increase inequality a lot, incentives to enforce payments are reduced Why? Not enforcing now brings the bene ts of defaulting on foreign payments If nancial liberalization lowers enforcement (E A = S, E T =?) ) CA surplus and lower welfare Autarky borrowers become constrained and cannot borrow now Autarky lenders lend at worst terms or become constrained

10 Financial liberalization revisited: the case of weak institutions Example #2: Why does financial liberalization increase consumption volatility? (Insurance model) Assume y G > y B and = + Assume E A = E T = fbg Before liberalization, there is both individual and country autarky c ib = y ib c B = y B and c ig = y ig and c G = y G After liberalization, we have instead that 8 < c ib = : where I U = fi 2 I jy ig y ib g 2 (y ib + y ig ) if i 2 I U y ib if i =2 I U and c ig = 8 < : 2 (y ib + y ig ) if i 2 I U y ig if i =2 I U c B = y B 2 (y ib y ig ) and c G = y G + U 2 (y ib y ig ) U Aggregate consumption volatility increases Welfare increases: I I U are not a ected, I U are better o and get insurance now If E A = E T = fgg, welfare still increases but aggregate consumption volatility decreases

11 Financial liberalization revisited: the case of weak institutions Example #2: Why does financial liberalization increase consumption volatility? How does nancial liberalization a ect enforcement? Before liberalization, there is enforcement if i A yib 0 and y B i A yig y G 0 After liberalization, there is enforcement if i T yib 0 and y B i T yig y G y G 2 (y B + y G ) (> 0) Unless terms-of-trade e ects increase inequality a lot incentives to enforce are not a ected in bad times incentives to enforce are reduced in good times since it means defaulting on foreign payments If nancial liberalization lowers enforcement in good times (E A = S, E T = fbg) ) higher consumption volatility and lower welfare Pro-cyclical become constrained and cannot get insurance now Counter-cyclical get insurance at worse terms or become constrained

12 Investment and growth Assume now that there is investment Today, k i, and production Tomorrow, F is (k i ) Individuals now maximize subject to FOC s are given by = (c i0 ) + (c i0 + k i y i0 ) + s2u i s u 0 (c is ) = s2s c is y is 8 < : R s F 0 is (k i ) + s2s s (c is ) s (c is F is (k i )) R s 0 if s =2 E u 0 (c i0 ) R s u 0 (F is (k i )) if s 2 U i if s =2 U i s u0 (F is(k i )) s=2u i u 0 (c i0 ) F 0 is (k i ) U i = fs 2 S : s 2 E or u 0 (c i0 ) R s u 0 (F is (k i ))g With strong institutions (E T = E A = S), nancial liberalization raises investment and growth With weak institutions (E T and E A endogenous) investment and growth might fall since unproductive individuals invest less and lend abroad decline in enforcement and welfare more likely due to potential e ect of liberalization on investment

13 Final remarks What are the e ects of nancial liberalization? We focus on consumption, investment, growth, and welfare Conventional view is that consumption stabilizes, investment and growth increase, and welfare improves But we nd that when institutions are weak nancial liberalization might lead to increase in consumption volatility current account surpluses reduction in investment and growth decline in enforcement The net e ect on welfare might be negative if the decline in enforcement is severe enough