Credit constraints, equity market liberalization, and growth rate asymmetry

a r t i c l e i n f o JEL classification: E32 F36 G15 Keywords: Financial openness Business cycle asymmetry Development This paper provides evidence that financial openness is an important determinant of growth rate asymmetry in emerging markets. I exploit exogenous shocks to financial flows and examine the impact of equity market liberalization on the skewness of output growth for 93 countries during the 1973–2009 period. I show that opening the economy to foreign portfolio investment results in a substantially higher negative skewness of output growth. This result obtains with equal strength in the aggregate data and in the sectoral data, and it is disproportionately stronger in sectors that require more external finance. The skewness effect of financial openness is stronger in countries which experienced a banking crisis after liberalization. It is well known that the behavior of macroeconomic aggregates such as output and investment exhibits an asymmetric growth pattern: booms are generally gradual and long-lasting, with growth rates not far from trend, while downturns are generally sharp, with growth rates far below trend for a short period of time Most theoretical mechanisms proposed to explain this pattern rely on a learning process in which either bad signals are more extreme than good signals, or signals are less noisy during booms. 1 This view, however, abstracts from market frictions that may arise from agency problems, leading to an amplification of fundamental shocks in the presence of binding borrowing constraints. For example, credit frictions can amplify the effect of negative credit shocks on asset prices and this effect can be transmitted across countries in a financially integrated world This mechanism implies that while growth rate asymmetry in itself may be hardwired in the business cycle for reasons unrelated to properties of credit markets, its evolution over time may be intimately related to changes in the availability of external finance. Since 1980 many emerging markets have lifted restrictions on cross-border financial transactions. Consequently, economic research has fo-cused intensely in recent years on the effect of financial openness on output growth rates. The evidence shows that financial liberalization is associated, causally, with better prospects for future growth (e.g., However, while there is strong evidence that shocks to trend growth are the primary source of fluctuations in emerging markets, as opposed to symmetric transitory fluctuations around the trend (Aguiar and Gopinath, 2007), there has been no systematic attempt to link empirically …